There are many options available for obtaining credit funds: pledges, third party sureties, insurance, warranty and so on. And this is not the whole list. These options include financial covenant. This is another additional guarantee in debt repayment.
The essence of covenant
According to legal documentation, a covenant is a contractual obligation that a borrower gives to a lender. This document contains a list of clearly defined actions that the borrower is obliged to perform or not to carry out during the entire term of the loan agreement. If the borrower does not comply with the provisions that contain covenants in the loan agreement, this gives the lender the right to default to him. That is, the bank may require to return to him the entire loan balance and interest on it.
Varieties of Covenants
Credit covenants can be divided into active obligations, that is, the borrower is obliged to perform a number of specific actions, and passive obligations, that is, the borrower has the right to refuse to perform any actions. In general, covenant is a more acceptable option for lending to legal entities, but, in principle, individuals can use it. Suppose a borrower may be required to submit to a credit institution documents such as a statement of income or insurance on collateral.
Financial covenants
Financial covenants are directly related to the economic performance of the borrower, and more precisely, he supports them to a certain extent. For example, the largest or smallest values are determined for the value of personal stocks of assets, indicators of the productivity of equity, amounts of receivables, and so on.
The main advantage of financial covenant is that it allows you to significantly reduce the size of the loan, since the bank in this case receives additional guarantees and the ability to repay the loan in full if the obligations are not fulfilled. In addition, during a difficult economic situation, the covenant can be used by the borrower as evidence of its stable position. Banks today are selective at the time of signing the agreement, and the covenant is a great opportunity to gain the trust of a credit institution.
Challenges and Benefits of Covenant
The main goal of the covenant is to reduce the total amount of borrowed funds and to convince the creditor of the reliability of the client. If it is possible to determine the responsibility of the parties to credit relations, then the accuracy of the forecast of the risk of negative events increases. The borrower, observing the obligations of the contract, does not go beyond the coefficients of receivables and equity. If all his actions are consistent with the described conditions, then the covenant is active, if there are violations on the part of the client, then it is passive.
A financial covenant determines a client’s ability in relation to his solvency for a specified period, but he is not considered a financial ratio. Important in this case are collateral assets, liquidity, profitability and profitability ratios. If the covenant is difficult to calculate, then, most likely, during the trial, the court will support the side of the borrower.
In order for covenants to be expedient, information accessibility in relation to the company is important. The borrower must report on its income for the reporting period, make payments on time and annually insure collateral. The terms of the covenant include the obligation of the borrower not to mortgage his own property, not to change the scope of his activities.
The company may be subject to restrictions on the reduction of dividend payments, additional raising funds from other credit institutions, and the alienation of capital goods. The Bank thus tries to control the cash flows of the enterprise. If the borrower does not fulfill the established obligations, the lender can increase the interest rate, change the existing provisions of the covenants or require additional security.
