What is a Covenant?

A covenant is a contractual arrangement in which a borrower is not allowed to do certain things, in exchange for taking on a loan from a lender. These restrictions usually relate to the following issues:

Dividends. The borrower cannot pay dividends for the term of the loan, in order to reserve more cash for loan repayments.
Share buybacks. The borrower cannot buy back any of its own shares for the term of the loan, in order to reserve more cash for loan repayments.
Liquidity ratio. The borrower cannot report an excessively low liquidity ratio, since this indicates that the firm is not sufficiently liquid to pay off its loan.

If the borrower breaches the covenants, then the lender can demand immediate payment of the underlying loan.

Classifications of Debt with Covenants

A covenant violation may give a lender the right to demand immediate payment of the loan. A debt obligation should be classified as non-current on the borrower’s balance sheet, unless there has been a covenant violation that gives the lender the right to call the debt, and it is probable that the entity will not be able to comply with the covenant within the next 12 months. If both of these criteria have occurred, then classify the debt as a current liability.

Do not classify a debt as a current liability if the lender has waived the right to demand repayment for more than one year, the entity has cured the covenant violation, or it is probable that the entity will cure the violation within the specified grace period. In these cases, the debt can be classified as a long-term liability on the borrower’s balance sheet.

Disclosure of Loan Covenants

A borrower usually has to disclose the existence of debt covenants in the notes that accompany its financial statements. This disclosure encompasses the restrictions imposed by each covenant, the debt arrangement with which it is associated, and whether the borrower is currently in compliance with these restrictions.