Debt Covenant Violation and Debt Covenant Hypotheses

Debt Covenant

Xueting Ying

Yanjun Liu

Stetson School of Business, Mercer University

December 2015

Table of Contents

Description of Debt Covenant        

The Risk of the Lenders        

Restrictions of debt covenant        

Debt Covenant Violation and Debt Covenant Hypotheses        

Reference        

Description of Debt Covenant

Debt covenants, also called banking covenants or financial covenants, are agreements between a company and its creditors that the company should operate within certain limits.

The main role of debt covenants is to limit the behavior of debtors and ask them follow the certain principles and purpose when they are working. It is helpful for creditors to protect their legitimate rights and interests, because they can restrict the debtor by a formal debt contract. For example, creditors may restrict the dividend payments of the companies, repurchase the shares and get new debt. In addition, debt covenants may also require debtor to maintain a certain level of working capital, the interest coverage ratio, the total value of net assets and other financial indicators. Obviously, the choice of accounting policy determines the measurement and evaluation of these monitoring indicators, and it also help to evaluate whether the debt covenants was executed.

The accuracy of the debt covenants determines their risk of creditors and debtors. The goal of the debtor is to find the strategy to maximize the funds that we need, and the security of the debt must be the most significant thing that should be considered as early as possible. After thinking about security of the debt, we should pay attention to the the interest income. Thus, in the process of signing the debt covenants, the creditors will make restrictions or requirements to the factors that may affect the security of debt such as flow rate and the direction of using the funds. There is no doubt that from the perspective of the debtors, they do not want the creditors to add too many restrictions onto their business decision-making. Therefore, the process of signing the debt covenants is always the result of bargaining or a game.

However, the covenant itself is not complete. We have to say that there would be a lot of risk result from the security of debt and interest income that might happen in the future business of a firm. It is impossible for creditors to eliminate all of the risks by using the terms of the debt covenant. It also gives debtors chances to damage the interests of creditors (increase the debt risk) by using the defects of the terms signed in the debt covenants.

The Risk of the Lenders

From the process of signing the debt covenants and the strategy that the debtors use the fund, we can easily conclude that the creditors are mainly faced with the following risks: