Debt Covenant Reporting: A Quick Guide

Businesses require a cash flow system in their hands to meet certain requirements. For timely bill payments, employees’ salary reimbursement, and day-to-day obligations, adequate cash flow management is an important requirement for every business unit. Companies still rely on debt financing to fulfill their financial obligations. Lending agencies and firms specify criteria and standards to get funds from them. 

Lending firms are concerned with the financial status of the companies to whom they are going to lend finance. For this, they require a debt agreement for evaluating the company’s financial health and target meeting capability. Mostly, lenders search for the companies who make timely financial reporting and updates regarding performance related to debt agreements.

A covenant report is an important document for a debt agreement between lending and borrowing companies. This article will guide you about Debt Covenant reporting and its related aspects.

Debt Covenant Report

To get funds from lending agencies, companies enter into a debt agreement that specifies various targets to meet in a stipulated period. Most targets are concerned with the financial performance, profitability, solvency, and liquidity of a company. A Debt Covenant report, a financial document on behalf of the borrowing company, covers the performance concerning specified targets. It restricts and prohibits various activities liable to reduce firm performance. Specifically, a Covenant analysis report:

  • Prescribes targets for borrowing companies that they are required to meet in the specified time.
  • Specifies targets in terms of solvency, liquidity, and profitability.
  • Restricts companies from performing insignificant functions for improving financial performance.

Debt-covenants of Debt Covenant Report

Management of borrowing firm makes a report for the lender in terms of the following targeted measures:

  • Financial performance targets: As per the debt agreement between both parties, management needs targets for expenditure, cash inflow, cash outflow, and EBITDA (Earnings before interest, tax, depreciation, and amortization). Management needs to comply with specific benchmark limits to remain in the agreement.
  • Liquidity and solvency targets: To maintain adequate liquidity, different ratios such as current ratio, quick ratio, and acid-test ratios are primarily used for targets. Along with these parameters, the Debt-to-Equity ratio, Debt-to-Assets ratio, Fixed obligation ratio, and Interest coverage ratio are used to specify minimum limits for solvency measures.
  • Profitability targets: Repayments to debt financing rely on the profit of the firms. For this, the Covenant analysis report provides profitability targets measuring Net Profit margin, Gross Profit margin, Operating Profits, and Earning before interest and tax.

Compliance reporting for Debt Covenant analysis

Companies, under a debt agreement with a lending firm, comply with these parameters and standards. For this, management needs to report with regards to performance. In reporting, management makes a compliance report, indicating that all targets have been met within the specified time. 

Non-fulfillment of targets leads to certain penalties, breach of agreement, and repayment of full payment before the maturity period.

Need and importance for covenant reporting

Debt financing from banks and commercial banking units requires target compliance reporting. Borrowing companies use these reporting parameters especially, debt covenant clauses for various significant points:

  • Management of risk regarding non-compliance. Pre-defined parameters protect companies to timely maintain the covenants like profitability, solvency, and liquidity. 
  • Proper reporting ensures protection from default. By fulfilling financial parameters, breach of debt agreement can be avoided.
  • Information regarding financial health provides the potential to obtain additional debt finance from other institutes.
  • Financial reports are audited by independent auditing agencies. Thus, they provide a base for assessing credibility.

Borrowers use Debt Covenant analysis and reporting for establishing good relations with lending institutions. A good report not only assists in avoiding unpleasantness, rather it can be a useful tool for a company to assess important insights. Managers can evaluate companies’ financial matrix to take future financial decisions concerning capital structure. Debt covenants involved in reporting provide useful information for selecting additional fundraising options.

Conclusion

For getting a loan or debt financing from any lending firm, a debt agreement and Debt Covenant Reporting occupy an important place. Proper compliance concerning financial parameters assists in drawing successful lending agreements. Covenant reporting specifies various targets for borrower companies that are needed to be met within the prescribed time. Timely reporting assists management in dealing with core debt financing and other financial decisions also.