Debt Covenant

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What It Means

A Debt Covenant is a contractual requirement that directs a borrower to perform, or refrain from performing, specific activities. Debt Covenants can be Positive, detailing actions a borrower must perform, or Negative, detailing actions a borrower cannot perform.

Examples of Positive Covenant Requirements:

  • Audited financial statements

  • Insurance coverage

  • Record keeping

  • Maintenance of assets

  • Financial ratios

Examples of Negative Covenant Requirements:

  • Pay dividends to shareholders

  • Borrow more debt

  • Sell certain assets

  • Issue new stock

  • Invest in new capital equipment

Why It’s Important

Debt Covenants are intended to protect lenders and align interest between a lender and a borrower, but they can have serious consequences. Depending on the specific terms in the debt agreement, when a Debt Covenant is violated the lender may have the right to demand repayment of the loan, convert the debt to equity, or even force the company into bankruptcy. It’s important to consider the terms and potential consequences carefully before accepting any debt offering.

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