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Debt Limitation Definition

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Updated May 24, 2023

What Is Debt Limitation?

Debt limitation is a bond covenant that seeks to protect current lenders by restricting the amount of additional debt that the issuer might incur. It involves debt covenants included in the initial debt agreement that prevents additional debt from being taken on until the current debt reaches maturity.

Key Takeaways

Debt limitation is a bond covenant that seeks to protect current lenders by restricting the amount of additional debt that the issuer might incur.
Debt limitations utilize leverage ratios, such as degree of leverage (DFL), to identify if the company can afford to take on additional debt.
Debt limitation agreements may also apply if there is a fear that the company may issue junk bonds.

Understanding Debt Limitation

Simply put, debt limitation, also known as debt covenants, is a bond agreement, which limits any additional debt being incurred by the issuer before the outstanding bond reaches maturity. Covenants are affixed to the debt instrument to protect the bondholder (lender) by lowering the probability of default and minimizing the potential losses should a default occur.

Debt limitations are intended to shield current lenders by maintaining a firm's degree of leverage (DFL). This leverage ratio measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its operating income.

If operating income and earnings per share are relatively stable, then the company can afford to take on significant debt; however, when the company works in a sector where operating income is quite volatile, it may be prudent to limit liability to manageable levels.

Types of Debt Limitations

A debt limitation may take a variety of forms, depending on the circumstances of the debt issue. For financially sound firms, lenders may only want to maintain the current levels of leverage and implement a covenant relating to the debt-service coverage ratio (DSCR).

When the ratio of debt to revenue grows too large, a business will no longer be capable of paying its obligations. In corporate finance, DSCR is a measure of the cash flow available to pay current debt obligations. The ratio states net operating income as a multiple of debt obligations due within one year, including interest, principal, sinking fund, and lease payments.

This debt-servicing covenant would allow the firm to borrow more funds as it increases its net income. If the firm appears risky, lenders may not want it to incur additional debt. The covenant may specify a maximum level of debt in a dollar amount, despite any growth in operations.

Debt/equity, debt/capital, and debt/EBITA are financial ratios that companies can use to assess their debt profile.

If limitations are in place for a specific type of debt, or for funds earmarked for particular purposes, the covenant or agreement is known as a debt basket.

In more extreme cases, lenders may demand the company not take on additional debt until repayment of their bond is complete. The more restrictive forms of debt limitations are most likely to be implemented when the issuer’s financial status is questionable or unstable. Debt limitation agreements may also apply if there is a fear that the company may issue junk bonds.

The Gross debt-service ratio (GDS) is also a basis lenders use to assess the proportion of housing debt that a borrower is paying in comparison to their income. Also, debt limitation is different from a debt limit, which is the maximum amount of debt a country or its government is allowed to take on, as dictated by law.

Debt Covenants

A covenant is a protective instrument included in investing or borrowing agreements. The covenant is designed to help protect lenders and investors by decreasing the odds that a borrower will default. Debt limitation agreements also help in minimizing the financial obligations and commitments a borrower can incur which may compete against their existing debt agreements.

These covenants are legally binding and enforceable. A debt limitation is just one type of covenant. There are numerous other types. Some of these include restricted payments, limitations on liens, and limits on sales of equity interests.

Restrictive conditions may also happen with the sale or merger of assets. Covenants are especially frequent with high-yield bonds. Incurrence covenants occur with high-yielding bonds. These agreements only trigger when the company takes a specific action, such as when it incurs additional debt.

What Is the Benefit of Debt Covenants for Borrowers?

For borrowers, the benefit of debt covenants is the ability to obtain lower borrowing costs on their debt. Because borrowers have to agree to the various conditions imposed by lenders in the covenant, the interest rate and borrowing costs are usually lowered so that the borrower agrees to the terms.

What Is the Disadvantage of a Debt Covenant?

Debt covenants can have many disadvantages depending on the type of covenant. For example, a performance covenant could be difficult to abide by continuously or lenders could expect performance levels that are not realistic to achieve. Other debt covenants may prevent a borrower from taking on additional debt which might actually help their financial situation.

How Are Debt Limitations Enforced?

Debt limitations are enforced by covenants. This can be achieved in many ways, such as if the covenant is breached, the lender may pull funding, may change rates, or may mark the loan in default.

The Bottom Line

Debt limitations help protect lenders by preventing borrowers from taking on additional debt until the current debt reaches maturity. This helps keep leverage for the borrower at a certain level so that they are able to efficiently furnish their current debt and not default.

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