What Are Financial Covenants?

Financial covenants are part of the terms and conditions found in any type of financial contract. The covenants represent specific commitments that all parties involved in the contract are making to one another and outline what type of actions may be pursued in the event those covenants are not observed. Typically, care is taken in drafting the financial covenants so that there is little to no room for misunderstandings regarding what is meant by each covenant found within the body of the contract, and who is responsible for making sure that covenant is fulfilled.

One of the easiest ways to understand how financial covenants function is to consider the content of a loan agreement. Within the text of that agreement, the lender is making certain promises or covenants to the applicant, in the form of approving the loan under certain conditions. In return for receiving the loan, the borrower is agreeing to make payments on the outstanding balance in accordance with the schedule of payments outlined, use specific means of communicating with the lender should certain events come to pass, and in general honor all the stipulations set forth by the lender within the body of the contract. Should a borrower fail to comply with one or more financial covenants in loan agreements in place with different lenders, those lenders have the right to take any action identified in the body of the agreements, up to and including the right to declare the loans in default and call for the immediate settlement of the debt.

Financial covenants are also found in contracts between vendors and their customers. Typically, the covenants have to do with the timely payment for goods or services rendered to the client, with provisions that allow for the inclusion of late fees or other penalties if the remittance is not made within terms. For example, the contract between a vendor and a client may call for the addition of late fees if a payment on an invoice is not received within 30 days of issue. Those fees are then applied to the balance on the customer’s account and will usually be included on the next invoice. In some instances, the financial covenants may also commit the vendor to providing some sort of credit to the customer in the event the invoices are paid within a shorter period of time, such as ten days or less from the issue date.

The purpose of financial covenants in any type of working contract is to make sure that all parties understand the nature of the commitments they are taking on as part of their responsibility to one another. By including the covenants within the body of a contract, and using verbiage that is very direct and concise, the opportunity for any party to be unaware of his or her responsibilities is kept to a minimum. At the same time, the inclusion of financial covenants also protects the interests of all parties and goes a long way toward preventing losses as the result of entering into the agreement.