What are the three main types of covenants?

The three main types of covenants are affirmative, negative, and financial. These covenants are integral components of debt agreements that establish specific guidelines for the borrowing company's operations and financial health.

Affirmative covenants require the borrower to take certain actions, such as maintaining insurance, complying with applicable laws, or providing regular financial statements to lenders. These covenants are intended to ensure that the borrower adheres to activities that support their ability to repay the debt.

Negative covenants, on the other hand, place restrictions on the borrower, prohibiting certain actions that could jeopardize their financial stability or the lender’s interests. These might include limitations on additional debt, asset sales, or dividend payments, aimed at protecting the lender by ensuring the borrower does not take on excessive risk.

Financial covenants specifically relate to the borrower's financial metrics, often establishing thresholds for ratios such as debt-to-equity or interest coverage ratios. These serve as benchmarks to help lenders assess the ongoing financial health of the borrower.

Understanding these covenants is crucial because they play a significant role in risk management and the protection of both lenders and borrowers in financial agreements.