A financial covenant is a clause in a loan agreement that commits the borrower to operate within predefined financial constraints.
Its purpose is to impose a level of financial discipline on the borrower such that the borrower acts within the limits imposed by the constraints. The clause also aims to prevent the borrower from acting in a manner that is likely to reduce credit worthiness during the time period that the loan is outstanding.
For example, an interest cover covenant might state that interest cover will be no less than 3 times; the borrower promises that the ratio will always exceed the set figure.
Financial covenants are tested at certain pre-determined intervals; annually, in the above example.
Commonly used financial covenants on loan agreements, in addition to minimum interest cover, include:
1. Minimum tangible net worth – as this is a measure of solvency
2. Ratio of maximum borrowings to tangible net worth – to preserve the level of solvency
3. Net or gross debt to EBITDA (times) – measure of liquidity
4. Ratio of current assets to current liabilities, and minimum level of working capital – which are other measures of liquidity
5. Limitations on payment of dividends as a ratio of earnings – to preserve net worth
Breach of a financial covenant would normally constitute an event of default.