Debt covenants are agreements between a company and a creditor usually stating limits or thresholds for certain financial ratios that the company may not breach. Their projection is a vital component of a financial model.
Depending on the debt contract, a covenant breach can allow the lender to convert its debt to equity, demand full payback of the loan, initiate bankruptcy measures or adjust the level of interest payments. Covenants can also be non-financial and for example include specific events, such as change in ownership of the firm. For creditors, covenants are "safety nets" that allow them to reassess their lendings when a risk situation has changed.
Typical financial debt covenants are
- Interest cover, equity ratio, the loan life coverage ratio (LLCR), the project life coverage ratio (PLCR) or other liquidity and solvency ratios
- Return on assets, EBITDA margin or other profitability ratios
- Other financial indicators such as capex divided by depreciation
- Other indicators that may relate closely to the client's business, e.g. passenger load factor percentage for airlines (although these are often of only subordinate interest to the lenders)
Covenants are often a crucial component in the financial planning of a company for all parties involved. For usability reasons, a lot of banks will ask for dedicated covenant reports within a financial model, preferably with diagrams. You should take that into consideration when planning your model, as you can greatly increase your bank's (or client's) satisfaction by including just a few simple formulas and diagrams.