Debt covenants are terms of the debt agreement (Indentures) raised from banks or public debt markets. There are three types of covenants- Affirmative covenants, Negative covenants, and Financial covenants.
- Affirmative covenants require that the borrower undertake certain things, such as regularly submitting financial statements to the lender, keeping insurance policies in check, etc.
- Negative covenants restrict the borrower from doing certain things, such as taking on additional debt, selling assets, etc.
- Financial covenants require that the company maintain certain financial metrics in a given range, such as maintaining a minimum Interest coverage ratio, a minimum debt/EBITDA ratio, etc.
Ensuring that all the covenants are complied with is a daunting task. And even after taking care of it, violations may happen, which may be costly for the company. So, it is necessary to perform Covenant testing to ensure no violation happens.
Ensuring compliance with all debt covenants is difficult, as a company might have multiple debts with varying terms and requirements. So, it is important to perform Covenant testing on a monthly basis or at least a quarterly basis. Covenants testing ensures that the company is not already violating any covenant, and if any violation is expected in the future, then adequate steps can be taken beforehand.
The company’s updated financial model is the most important tool for performing covenant testing. A financial model includes historical and forecasted Income statements (IS), Balance sheets (BS), and Cashflow statements (CFS). Based on IS, BS, and CFS, various financial metrics, ratios, etc., can be computed, and they can be compared with requirements under debt covenants. This way, it can be concluded whether the company is or expected to violate debt covenants or not.
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