What are 'financial covenants' in loan agreements?

Financial covenants are specific clauses included in loan agreements that require the borrower to maintain certain financial ratios throughout the life of the loan. These ratios, such as debt-to-equity, current ratio, or interest coverage ratio, are intended to ensure that the borrower remains financially healthy and capable of meeting their repayment obligations. By monitoring these ratios, lenders can assess the ongoing creditworthiness of the borrower, and if the borrower fails to maintain the agreed-upon metrics, it could lead to default or the lender taking action to protect its interests.

This concept is crucial in lending relationships as it reflects a proactive approach in risk management by lenders. Instead of being passive, lenders actively track these covenants to avoid potential losses and maintain a check on the borrower's financial stability.