Debt covenants are conditions that lenders, including investors, debt holders, and creditors state in agreements to limit the activity of the borrower (the debtor). Debt covenants are agreements between an organization and the lenders that they will act within the policies set by the lenders. They are also known as banking covenants or financial covenants. A covenant analysis gives a picture of whether these policies are followed or not.
Purpose of Debt Covenants
Debt covenants protect lenders by mitigating the risk for creditors and providing recourse if there is a breach of the covenant as it is legally binding. It is done by restricting the activity of borrowers that may adversely affect the ability to repay the loan.
What is a debt covenant report?
A debt covenant report is a document that covers how the lender or his company performed, concerning the terms specified by the lender and agreed to by the borrower in the debt covenant. A debt covenant report provides benchmarks to assess the lender’s performance against set targets.
The management of the organization is required to give a compliance certificate to the lenders. It is to specify that the terms for a particular period are met. If the lender fails to comply with the covenant’s agreement, it may lead to a penalty or a recall of the entire payment.
A debt covenant report usually calculates the borrower’s performance on the given criteria:
- Liquidity and solvency ratios: Solvency refers to the borrower’s potential to meet long-term financial commitments that may stretch beyond a year. Liquidity refers to the borrower’s capability to repay short-term liabilities. It also includes the borrower’s capability to sell assets to raise money. These assess the lender’s potential to fulfill financial commitments both in the short term and long term.
- Profitability ratios: This helps evaluate the lender’s capability to generate income in comparison to the costs. These include Gross Profit Margin (the net of revenue minus cost of goods, then divided by revenue). Operating Profit Margin (net operating income divided by revenue).
- Other financial indicators: These include earnings, capital expenditure, and Earnings before Income, Taxes, Depreciation, and Amortization (EBITDA)
- Operational indicators: These include the total volume of sellers and buyers, and the return on investment for any specified assets amongst others.
Why is a debt covenant report Important?
- Positive Relationship: Debt covenant reports help the borrower to maintain positive relationships with creditors. The chances that credit will be extended next when required is high. The likelihood that lenders will recall existing loans before they are due is less.
- Outline conditions: When a borrower takes credit or applies for one, the ensuing agreement involves terms of financial conduct and other conditions. These terms and conditions outline the performance that a borrower needs to continue to maintain the credit under standard norms. Borrowers are expected to produce the debt covenant reports on a monthly/quarterly/half-yearly or yearly basis.
- Outline the dos and don’ts: Debt covenant reports state what the borrower is required to do and what he is restricted from doing. Debt covenants often provide a profile on the financial metrics that the borrowing organization is expected to maintain.
- Management Tool: Several components of a debt covenant report are useful in measuring the aggregate achievement of the borrower. It is done by looking into the liquidity, solvency, and capacity to generate profits. It assists managers in formulating the best capital structure for the company. It also helps in deciding whether additional debt should be taken or while looking to increase investments in equity.
- Measuring future performance: Several of the parameters on a debt covenant report can be helpful in forecasting revenue to be earned and comparing the present performance to the past. It can also give an insight as to the borrower’s standing in the industry in comparison to others in the same line of business.
- Build reputation: A debt covenant report assists in establishing the borrower’s credibility with lenders. It helps to build a creditworthy reputation. Reporting accurately and on time will assist the borrower in staying compliant and assist in raising further funding in case a need arises. It also helps to avoid the risks related to non-compliance and the risk of penalties thus arising.
Why do you need a technology partner?
A debt covenant report is an important document encompassing many factors. It is necessary to incorporate all the terms and measures correctly to track the performance on a detailed basis. It is not easily done and requires a thorough covenant analysis. When done manually and on standard software, all the measuring tools like ratios may not be captured. It requires a fast and scalable covenant monitoring solution. Acuity Knowledge Partners provide a specialized solution known as CovenantPulse for this purpose. It provides an in-depth understanding of covenant performance, delivers early warning signals of deteriorating covenant quality, and generates advanced covenant analytics. It is cost-effective, has a shorter turnaround time, strengthens credit risk governance, and provides standardized output.
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