Final answer:
Incurrence covenants restrict a borrower's actions unless certain financial conditions are met, for example, limiting additional debt unless a certain earnings ratio is met. Maintenance covenants require maintaining specific financial ratios throughout the loan term, such as a minimum interest coverage ratio. Both protect lenders by promoting financial health and minimizing default risk.
Step-by-step explanation:
Incurrence covenants and maintenance covenants are both types of restrictive covenants found in finance, particularly in the context of lending agreements or bond indentures. Incurrence covenants are conditions that limit the borrower’s actions unless certain financial tests are met at the time of the action. For example, a company may be limited from taking on additional debt unless it can meet a ratio of earnings to fixed charges. Maintenance covenants, on the other hand, require the borrower to maintain certain financial ratios or metrics throughout the life of the loan, such as a minimum interest coverage ratio or a maximum leverage ratio.
Examples of Incurrence Covenants
Limits on additional debt
Restrictions on paying dividends
Asset sale restrictions
Examples of Maintenance Covenants
- Debt to equity ratio requirements
- Minimum working capital levels
- Interest coverage ratio maintenance
Both types of covenants are designed to protect the lender by ensuring that the borrower maintains a certain level of financial health and is not taking excessive risks that could jeopardize their ability to repay the loan.