Security Provisions and Protective Covenants Security provisions and protective covenants in loan documents are intended to ensure that the principal and interest of outstanding loans will be repaid in a timely fashion. Typical security provisions include the assignment of payments due under a specific contract to the lender, an assignment of a portion of the receivables or inventories, and a pledge of marketable securities held by the borrower. Others include a mortgage on property, plant, and equipment held by the borrower, and the assignment of the cash surrender value of a life insurance policy held by the borrower on key executives.
An affirmative covenant in a loan agreement specifies the actions the borrowing firm agrees to take during the term of the loan. These actions typically include furnishing periodic financial statements to the lender, carrying sufficient insurance to cover insurable business risks, maintaining a minimum amount of net working capital, and retaining key management personnel acceptable to the lending institution.
A negative covenant restricts the actions of the borrower. These actions include limiting the amount of dividends that can be paid, the level of salaries and bonuses that may be given to the borrower’s employees, the total amount of indebtedness that can be assumed by the borrower, investments in plant and equipment and acquisitions, and the sale of certain assets.
Cash-Flow or Unsecured Lenders Cash-flow lenders view a borrower’s future cash-flow generation capability as the primary means of recovering a loan and the borrower’s assets as a secondary source of funds in the event of default by the borrower.
Types of Long-Term Financing The attractiveness of long-term debt is its relatively low after-tax cost as a result of the tax deductibility of interest. In addition, leverage can help improve earnings per share and returns on equity. However, too much debt can increase the risk of default on loan repayments and bankruptcy.
Long-term debt generally is classified according to whether it is secured.