Covenant
A term written into a loan agreement constraining the borrower afterwards. It is what stops value being moved to shareholders once the money is lent.
Where you will meet it
Covenant appears in 20 learning outcomes on the CFA syllabus. A few of them:
- Explain how assets and liabilities are split into current and non-current
“The classification drives the liquidity ratios, which makes the boundary cases consequential: debt maturing within a year is current unless a right or agreement to refinance it long term is already in place, and a breached covenant can make long-term debt immediately current and turn a comfortable current ratio into a deficit overnight.”
- Set out the core characteristics of a debt security
“The indenture is the legal contract setting out these terms along with covenants — affirmative ones requiring the issuer to act, negative ones restricting it.”
- Say why debt covenants exist and what they do
“Covenants are contractual restrictions a borrower accepts in exchange for cheaper credit.”
- Explain problems that can undermine the quality of financial reports
“Low quality is more likely when motivation, opportunity and rationalisation coincide: pressure to meet targets or covenants, weak governance or auditors, and a culture that tolerates it.”
Practise it
Practise covenant until it is automatic: questions that explain every wrong option.
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