What are debt covenants?

2. Capital covenants and performance covenants

According to the accounting research literature, covenants that most commonly lead to technical default include net worth (or tangible net worth) and current ratio.

According to a research study by Christensen and Nikolaev (Journal of Accounting Research, March 2012), debt covenants can be classified as Capital Covenants (C-covenants) and Performance Covenants (P-covenants).

Capital covenants:

  • Align interests of debt holders and shareholders by requiring the borrower to maintain enough capital inside the company
  • Directly restrict the level of debt in the company‚Äôs capital structure
  • Are not suitable for all companies because of the stringent constraints on the capital structure
  • Rely on balance sheet information
  • Are formulated in terms of sources and uses of capital (e.g., debt-to-equity, loan-to-value, current, debt-to-tangible net worth, leverage, and senior leverage ratios).

Performance covenants:

  • Facilitate allocation of control to lender when the borrower violates a debt covenant
  • Serve as more timely indicators of poor economic performance and distress
  • Are complemented with negative covenants
  • Are used by financially constrained borrowers
  • Rely on income statement information alone or in combination with balance sheet information
  • Are formulated in terms of current-period performance or efficiency ratios (e.g., interest coverage, cash interest coverage, fixed charge coverage, debt-to-cash flow, and level of EBITDA ratios).
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