What is the difference between a financial covenant and a performance covenant in lending?

What is the difference between a financial covenant and a performance covenant in lending Introduction: The Significance of Covenants in Lending Hello everyone, and welcome to today's video. When it comes to lending, covenants act as crucial safeguards, ensuring that both the borrower and lender adhere to certain financial and operational parameters. Today, we'll be diving into the world of covenants, specifically focusing on the differences between financial and performance covenants. So, let's get started! Defining Financial Covenants: A Focus on Numbers Financial covenants, as the name suggests, revolve around the financial aspects of a borrower's operations. These covenants typically involve specific ratios or metrics that the borrower must maintain. For example, a common financial covenant could be the debt-to-equity ratio, which determines the proportion of a company's debt in relation to its equity. By setting such ratios, lenders can ensure that the borrower's financial health remains stable throughout the loan tenure. Performance Covenants: Beyond the Numbers While financial covenants focus on quantitative aspects, performance covenants take a more qualitative approach. These covenants often relate to the borrower's operational efficiency, market standing, or even specific milestones. For instance, a performance covenant for a manufacturing company could be the achievement of a certain production target within a given timeframe. By incorporating such covenants, lenders can gauge the borrower's ability to meet not just financial obligations, but also broader operational goals.