Final answer:
Debt covenants are restrictions or conditions in a debt contract that a borrower must follow. They include financial and operational covenants. If a firm violates a debt covenant, it can result in various consequences such as immediate repayment and damage to credit rating.
Step-by-step explanation:
Debt covenants are restrictions or conditions included in a debt contract that a borrower must adhere to. They help protect the interests of lenders by ensuring that the borrower meets certain financial and operational obligations. Two types of debt covenants are financial covenants and operational covenants. Financial covenants focus on the borrower's financial performance and include metrics like debt-to-equity ratio, interest coverage ratio, or minimum cash balance requirements. Operational covenants, on the other hand, pertain to specific business operations and can include restrictions on mergers and acquisitions, dividend payments, or changes in management. If a firm violates a debt covenant, it is considered a default on the loan. The lender may take action against the borrower, such as demanding immediate repayment, charging higher interest rates, or even taking legal action in extreme cases. Violating covenants can damage the borrower's credit rating and make it more difficult to secure future loans.