Limitation on debt: Overview, definition, and example
What is limitation on debt?
A limitation on debt refers to a restriction placed on the amount of debt that an individual, company, or organization can incur. This limitation can be set by internal policies, government regulations, or as part of a loan or credit agreement. The purpose of limiting debt is to ensure financial stability, prevent overleveraging, and protect stakeholders from excessive financial risk. It can be expressed as a maximum debt threshold, a debt-to-equity ratio, or a cap on specific types of borrowing.
For example, a company might include a limitation on debt clause in its articles of incorporation, stating that it cannot borrow more than a certain amount relative to its equity or assets.
Why is limitation on debt important?
Limitation on debt is important because it helps control financial risk and ensures that a company or individual does not take on more debt than they can manage or afford to repay. Excessive debt can lead to financial instability, increase the likelihood of default, and negatively impact credit ratings. For businesses, debt limitations provide a framework for sustainable growth and protect against the negative consequences of overborrowing. For individuals or organizations, limiting debt helps maintain a healthy balance sheet and improves long-term financial security.
In loan agreements, limitations on debt ensure that the borrower does not exceed certain borrowing thresholds, which could compromise their ability to meet repayment obligations. It also provides lenders with more assurance that the borrower will not overextend themselves financially.
Understanding limitation on debt through an example
Imagine a corporation, ABC Corp., has a policy that it will not take on debt that exceeds 40% of its total assets. This means that if the company’s assets are worth $10 million, the total debt it can carry is limited to $4 million. If the company is considering taking out a loan for expansion, they must ensure that the loan amount does not exceed this threshold, maintaining a healthy balance between debt and equity.
In another example, a bank might issue a loan agreement with a borrower that includes a covenant limiting the borrower’s total debt to no more than 50% of their annual revenue. If the borrower’s revenue is $2 million, they cannot incur more than $1 million in total debt according to this covenant. This limitation helps the lender ensure that the borrower remains financially stable and able to repay the loan.
An example of a "limitation on debt" clause
Here’s how a limitation on debt clause might appear in a corporate contract or loan agreement:
“The Borrower agrees that, for the duration of this Agreement, the total indebtedness of the Borrower shall not exceed [insert percentage] of its total assets, as calculated at the end of each fiscal quarter. The Borrower shall ensure that all debt obligations remain within this limit, and any violation of this limitation shall be considered a breach of this Agreement.”
Conclusion
Limitation on debt is a critical tool for managing financial risk and ensuring long-term stability for both businesses and individuals. By setting clear limits on the amount of debt that can be incurred, organizations can prevent overleveraging, avoid financial strain, and maintain solvency. These limitations are commonly included in corporate governance policies, loan agreements, and regulatory frameworks to protect stakeholders, investors, and creditors from the adverse effects of excessive borrowing.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.