What is the primary purpose of covenants in a loan agreement?

The primary purpose of covenants in a loan agreement is to ensure timely repayment and keep the bank informed about key aspects of the borrower's financial situation and operations. Covenants serve as a set of conditions that the borrower agrees to adhere to during the life of the loan. These can include maintaining certain financial ratios, providing regular financial statements, or adhering to a specific business plan. By establishing these requirements, banks can monitor the borrower's financial health and take corrective actions if certain thresholds are breached, which helps mitigate the risk of default.

Covenants are essential for maintaining a transparent and communicative relationship between the lender and borrower. They not only protect the lender's financial interests but also encourage borrowers to remain disciplined in their financial practices, thus enhancing the likelihood of timely repayment.