Financial Ratios and Credit Risk: The Selection of Financial Ratio Covenants in Debt Contracts

Abstract

This study examines the selection of financial ratio covenants in debt contracts. Expanding on existing theory and evidence, I predict that loan contracts will include covenants with ratios that are informative of credit risk based on borrower or contract characteristics. The results support this prediction. I find that contracts of borrowers with positive earnings, high profitability, and low volatility earnings are likely to include covenants measured with earnings, such as coverage or debt to cash flow. Debt contracts of borrowers with losses, low profitability, and highly volatile earnings are likely to include covenants measured with shareholders' equity, such as net worth. Additionally, deals with revolving lines of credit include leverage covenants, and those for borrowers with high levels of working capital contain current ratio covenants. In total, the evidence is consistent with contracts using ratios in covenants that are most informative of borrower credit risk.

Keywords: Debt Covenants, Bank Debt, Default Risk, Financial Ratios

JEL Classification: G21, G32, M41