Financial covenants have become increasingly important in corporate finance since the aftermath of the financial crisis. This article provides an overview of financial covenants and their use in corporate finance.
Definition and explanation
Financial covenants are additional contractual terms or ancillary agreements in credit and loan agreements that require the borrower to comply with certain financial requirements.
Exceeding or exceeding certain values may result in changes in the applicable margin or more serious consequences (breach of contract or similar).
The term financial covenants can literally be translated as “financial agreement” from English. However, the term Financial Covenant has already entered the German financial language and is therefore understood as “agreed financial ratios”.
The key figures agreed here may relate, inter alia, to equity , debt, liquidity, income and interest expenses. It is basically possible to make almost any conceivable key figures on financial covenants metrics.
The most popular financial covenants are the net leverage ratio and the interest cover ratio .
Both are therefore also so effective in combination, because the net debt is based on the reporting date, but the interest cover ratio is calculated on an ongoing basis. On the one hand, this gives you a rigid financial covenant (net debt) and a dynamic (interest coverage ratio).
In addition, gearing is often used as a key figure.
As part of a prolongation of the syndicated loan, a company receives a financial covenant as an additional condition, which determines the margin to be paid by the borrower in the subsequent period.
For this purpose, the margin grid/margin grid agreed in the contract :
applicable margin (in bp pa)
<3.5x to ≥ 3.0x
<3.0x to ≥ 2.5x
The Margin Grid makes it very easy to see which credit margin has to be paid on borrowers’ incurrence if the financial covenant net debt ratio reaches certain levels at the relevant reporting date.
The breach of compliance with financial covenants triggers a reporting obligation in accordance with IFRS 7, as disclosures about the company’s own credit risk represent decision-relevant closing information.
Non-financial covenants are other clauses in the credit agreement, which does not directly but indirectly affect the finances of the borrowing company. They also have the purpose of reducing or not further increasing the material credit risk for the lender.
Particularly noteworthy here are the pari-passu clause, negative declaration, cross-default clause or the collective action clause.
Meaning and distribution
In the course of the financial crisis, the financial covenants became increasingly important. The banks, which had become significantly more restrictive in their lending at the time, were able to gain some more control over what happened in the credit cycle. For the borrowing company, however, the overcoming of the agreement is manageable. After all, it is “t0” and no one is expecting that the planning could not happen.
And so today financial covenants are increasingly finding themselves in the larger German Mittelstand . There are agreements of financial covenants in the context of
- Club deals or syndicated loans ,
- Borrowing base financings or even
- Working capital loans.
In fact, every credit agreement can be supplemented with financial covenants. The Bank will only consider in individual cases to what extent the costs (agreement and monitoring ) and benefits (reduction in material credit risk) are in good proportion.
A further, very interesting read on the latest developments is offered by the Roland Berger study .
Headroom, in the context of financial covenants, refers to the leeway that still exists between Financial Covenant and the company’s budget.
A medium-sized company determines in its own planning at the end of the financial year 2018 a net debt ratio of 2.3x.
As a result, a covenant net debt / EBITDA amounting to 2.7x at the end of the financial year 2018 will be included in the loan agreement with the bank.
Accordingly, there is a headroom of around 17.4%.
If an agreed financial covenant is broken, there is a formal legal breach of contract. Accordingly, the bank can call the loan due and demand repayment.
While this may succeed in some cases, it will often turn the borrower into real financial threats.
As a result, the Bank generally has no interest in immediately terminating the loan agreement.
Instead, the borrower – as soon as it becomes apparent to him that compliance in the reporting period is not possible – a so-called “Waiver”.
Waiver in this context means that the lending bank renounces its right to terminate the loan from non-compliance with agreed financial ratios.
The bank will then scrutinize the client’s numbers and recalculate its credit risk before deciding whether or not to maintain the loan. Another consequence for the customer may also be a change in condition.
The bank will pay a processing fee for processing a waiver.