A debt covenant is a contractual agreement that establishes certain conditions or restrictions that the borrower must adhere to as a condition of the loan provided by the lender. These covenants are designed to protect the lender's interests and ensure the borrower maintains prudent financial practices during the duration of the loan. For example, a common debt covenant might require the borrower to maintain a specific debt-to-equity ratio or restrict excessive distributions of dividends.

Debt covenants typically fall into two categories: positive covenants, which require the borrower to perform certain financial or operational actions (e.g., providing regular financial statements to the lender), and negative covenants, which prohibit certain actions that could negatively impact financial stability (e.g., taking on additional debt beyond an agreed threshold). Violating any of these covenants, known as a covenant breach, could result in penalties or even acceleration of loan repayments. For example, if a company's debt covenant specifies maintaining a minimum current ratio of 1.5 and the company fails to meet this requirement, the lender may reserve the right to demand immediate repayment.

Understanding debt covenants is critical for businesses, especially those dealing with complex financial structures. It helps in making informed decisions that align with the terms of their credit agreements and avoid unnecessary financial risks.