Friday, 23 September 2011

Role of Covenants in credit analysis

Indenture is referred to as the lending agreement which contains terms and conditions. These terms and conditions are referred to as covenants. They deal with limitations and restrictions on the borrower's activities and play an important part in minimizing risk of creditors. Covenants could be termed as either Affirmative or Negative.

Affirmative covenants are those which require debtors to do certain set of activities to improve the credit quality of the issuer. Common examples include:
  • To pay all taxes and other claims when due
  • To maintain all properties used in the borrower's business in working order and good condition
  • To pay interest, principal, and premium, if any on timely basis
  • To submit periodic certificates to the trustee stating whether the debtor is in compliance with the loan agreement.
Negative covenants are the limitations which restrict borrowers not to take certain actions. Common examples include:
  • Limitations on the company's ability to incur debt
  • Use of cash flow tests and working capital maintenance provisions
  • Limitations on dividend payments and stock repurchase
  • Use of interest or fixed charge coverage test to reduce the default risk of creditors. The two common tests are:
    • Maintenance Test: This test requires the borrower's ratio of earnings available for interest or fixed charges to be at least a certain minimum figure on each required reporting date
    • Debt Incurrence Test: Debt incurrence tests are generally considered less strict than maintenance provisions.
Indentures often classify subsidiaries as restricted or unrestricted. The former are considered for financial test purposes while the later are not. If a firm has unrestricted subsidiaries they are allowed to used outside sources of funds and they are excluded from the covenants of the parent.

Covenants are among the other Cs of Credit Analysis. They are given equal preference while checking the credit quality of an organization. If organizations fail to abide by the covenants then creditors feel reluctant in lending money to such organizations.

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