Financial covenants are agreements or promises made by borrowing parties to lending institutions. When an individual or company borrows money from a finance provider, they agree to maintain an agreed financial ratio to repay the loan on time and avoid default. Typical financial ratios include total assets to loan, interest coverage, and debt-to-equity ratios.

Lending companies require regular covenant monitoring to ensure borrowers comply with the terms and conditions mentioned in the loan agreement. It helps them foresee the chances of bankruptcy to avoid loan default.

Below is an attempt to explore what function covenant analysis performs in bankruptcy protection.

Significance of Financial Covenant Analysis

Financial covenant analysis refers to creating a document covering the performance of an organization regarding the agreed-upon targets in the loan covenants. It specifies a borrower’s financial and operational targets for a particular period. It prohibits or restricts certain activities that might impact the borrower’s finances or performance and lead to bankruptcy. An analysis report benchmarks the performance of a borrower against specific targets.

A borrower’s finances must provide compliance assurance to the loan providers, indicating that they meet the specified targets for the loan tenure. Failing to meet the financial covenants often leads to penalties. If the lender perceives bankruptcy, they may even demand full payment before time. An analytical report typically measures a borrower’s performance on the below parameters:

• Solvency and liquidity ratios, assessing a company’s ability to fulfill short and long-term financial goals and commitments
• Financial indicators, including EBITDA, capital expenditure, and revenue
• The profitability ratio assesses a company’s earnings compared to expenses
• Operational indicators like the number of sellers and customers

Analytical reports for financial covenants work as a safety net for loan providers against bankruptcy. That is why they usually undertake it to minimize the risks associated with money lending. With debt covenants, loan providers make it legally binding for borrowers to maintain certain cash flow levels. By analyzing its adherence regularly, the loan company ensures the security and safety of its lent-out funds, protecting itself from the risks associated with a loan agreement.

To ensure protection against bankruptcy, the loan providers include financial covenants related to debt-to-equity ratio, interest coverage ratio, level of cash flow, EBITDA, EBIT, operating expenses, etc. A breach of financial covenants often gives the lender the right to collect collateral, call the loan amount, or demand a higher interest rate or penalties. The lenders may waive the covenants at their discretion, either temporarily or permanently. However, it depends on the loan provider, and the borrower usually has no power over this decision.

Financial covenant analysis is a means for borrowers to gain the lender’s trust. It protects the lending party against the risk of loan default due to the borrower’s bankruptcy. One major advantage of analysis for the lender is that it protects the money they lent to the borrower and assures repayment on time. When the borrowers are legally liable to maintain certain performance ratios and cash flow levels, they ensure financial stability by taking each step diligently.

Must Read: What Purpose Does Covenant Analysis Play in Banking Activities?