Definition
A Ratio Covenant is a specific type of covenant included in loan agreements, that stipulates certain financial ratios must be maintained by the borrowing company. The typical ratios included are the gearing ratio (a measure of financial leverage) and interest cover (a measure of a company’s ability to cover its interest payments). Breaching a ratio covenant could indicate significant deterioration in the company’s business or indicate a major change in the nature of the business. As a result, if a ratio covenant is breached, it often gives the lender the right to demand immediate repayment of the outstanding loan, effectively making the loan agreement void.
Examples of Ratio Covenant
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Gearing Ratio Covenant:
- The loan agreement requires that the borrowing company maintains a gearing ratio of no more than 0.5, which means that the company’s debt should not exceed half of its equity.
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Interest Cover Ratio Covenant:
- The borrowing company must maintain an interest coverage ratio of at least 3. This means that its earnings before interest and taxes (EBIT) must be at least three times greater than its interest expenses.
Frequently Asked Questions (FAQs) about Ratio Covenants
What is the main purpose of a ratio covenant?
The primary purpose of a ratio covenant is to protect the lender by ensuring that the borrowing company maintains a certain level of financial health and does not take on excessive risk that could jeopardize its ability to repay the loan.
Can a company negotiate the terms of a ratio covenant?
Yes, a company can negotiate the terms of a ratio covenant with the lender during the loan agreement process. Both parties may agree on specific ratios and acceptable thresholds based on the company’s financial situation and industry standards.
What happens if a company breaches a ratio covenant?
If a company breaches a ratio covenant, typically, the lender has the right to demand immediate repayment of the outstanding loan balance. This can lead to financial distress for the borrowing company if it does not have sufficient liquidity.
Are ratio covenants applicable to all types of loans?
Ratio covenants are more common in corporate loans, particularly in large-scale borrowing agreements, such as syndicated loans and bonds. They may not be as prevalent in smaller loans or personal loans.
How are ratio covenants monitored?
The borrowing company is usually required to provide periodic financial statements and reports to the lender. These documents are used to monitor compliance with the ratio covenants. Audited financial statements may also be required to ensure accuracy.
Related Terms with Definitions
Gearing Ratio
The gearing ratio measures a company’s financial leverage by comparing its total debt to its equity. Higher gearing indicates more leverage and higher financial risk.
Interest Cover Ratio
The interest cover ratio assesses a company’s ability to meet its interest obligations from its operational profits. It is calculated by dividing EBIT (Earnings Before Interest and Taxes) by interest expenses.
Covenant
A covenant in the context of finance refers to any clause in a contract or agreement that places specific obligations on one or more parties to the contract. It often includes specific financial metrics and conditions.
Online References
Suggested Books for Further Studies
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“Financial Accounting” by Robert Libby, Patricia A. Libby, and Frank Hodge:
- A comprehensive guide to understanding accounting principles and standards.
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“Corporate Finance: Core Principles and Applications” by Stephen A. Ross, Randolph W. Westerfield, Jeffrey Jaffe, and Bradford D. Jordan:
- This book offers insights into corporate finance fundamentals, including loan covenants.
Accounting Basics: “Ratio Covenant” Fundamentals Quiz
Thank you for exploring the concept of Ratio Covenants with us and testing your knowledge with our quiz. Keep advancing your financial literacy to excel in your professional endeavors!
