Asset-Related Covenants in Loan Agreements

Asset-related covenants are provisions included in loan agreements by financial institutions to protect their interests by ensuring the borrower maintains the value and security of the pledged collateral. These covenants are designed to limit the borrower’s actions regarding the management, disposal, or encumbrance of assets. Below are common asset-related covenants typically found in loan agreements:

Maintenance of Working Capital Ratios
- Current Ratio Covenant: The borrower may be required to maintain a minimum current ratio, indicating their ability to meet short-term obligations. This ensures the borrower’s liquidity is sufficient to cover operating costs.
- Quick Ratio Covenant: A more stringent version, the borrower must maintain a minimum quick ratio, which excludes inventory from assets and focuses on the most liquid assets.
Restriction on Creation of Further Charges on Assets
- This covenant prohibits the borrower from pledging or encumbering the same assets for additional loans or credit facilities without the lender’s consent. It ensures that the lender’s claim on the collateral remains senior to any subsequent claims.
Prohibition on Disposal or Sale of Assets
- Fixed Assets: The borrower may be restricted from selling, transferring, or disposing of fixed assets (such as machinery, buildings, or land) without prior approval from the lender. This is done to preserve the value of assets that serve as collateral.
- Current Assets: Restrictions may also apply to the sale of significant current assets (e.g., inventory or receivables), ensuring that the borrower maintains sufficient operational resources.

These covenants are meant to minimize the lender’s risk by ensuring that the borrower maintains its financial health and protects the value of the assets used as collateral. They are designed to maintain the lender’s priority claim and ensure that the borrower does not take actions that could jeopardize their ability to repay the loan.