With the term “Finance covenants” we often encounter it in contractual documentation in the field of finance. It frequently appears in loan agreements (bank vs. company), prospectuses for bond issuer programs, or other financial agreements between two or more parties.

What is a Financial Covenant – Definition

A financial covenant can be defined as an obligation to fulfill a certain condition within a contract or agreement. In the case of a loan agreement between a bank and a client (company), the bank’s motivation is to ensure the proper fulfillment of the contract—namely, the proper repayment of annuities or other defined payments.

Individual financial covenants are then part of the contractual documentation, where the debtor commits to fulfilling the covenants either temporarily (during a specified period) or for the duration of the contract. Typically, banks establish covenants using financial analysis indicators.

In addition to financial covenants, there are also, for example:¹

• Affirmative (positive) covenants – these are specific actions or activities that must be performed. We commit to fulfilling certain conditions upon which something will happen (e.g., the bank releasing funds). Example: maintaining insurance throughout the loan period, providing annual reports to the bank, etc. Violating these covenants can lead to sanctions or contract termination.
• Negative covenants – these involve actions or activities that must not be performed during the contract’s duration. For example, during the loan period, the company must not pay dividends, grant extraordinary management rewards, and so on. The bank’s typical goal is to maintain the balance sheet and liquidity indicators at the best possible level.

Financial Covenants – Example

Covenants are established depending on the type of contract and financing conditions, and their mixture depends on the agreement of the contracting parties. The purpose is to establish covenants in such a way that we simultaneously ensure:

• Adequate protection for the creditor (bank)
• Not crippling the economic capacity of the debtor

Typical examples may include these indicators:

• Debt-to-equity ratio – the bank safeguards the situation in which the client would want to excessively leverage and thus endanger their ability to repay.
• Interest coverage – another indicator of indebtedness, a similar function as in the previous case.
• Cash flow – we define a certain cash flow level that the debtor must generate.
• OPEX (Operating Expenses) – we define a certain level of operating expenses (to keep the company’s operating expenses at a reasonable level).
• and many others.

Monthly financial reporting of the balance sheet, income statement, and ratio indicators is typically used to monitor financial covenants.

Types of Financial Covenants

We can encounter various categorizations based on what the covenant relates to, such as:

• Debt covenants (indebtedness indicators)
• Asset covenants (activity or other indicators)
• Legal covenants
• etc.

1. Financial Edge, Covenants [on-line]. [cit. 2023-01-07]. WWW: https://www.fe.training/free-resources/banking/covenants/