What it means
When a lender, such as a bank, gives a loan, it wants to make sure it will get its money back. To do this, it attaches conditions, called loan covenants, that the borrower must meet for as long as the loan is outstanding.
These conditions help the lender feel secure about the borrower's ability to repay. Covenants come in three broad kinds.
Affirmative covenants say what you must do, such as providing financial updates or keeping insurance in place. Negative covenants say what you must not do without permission, such as borrowing more or selling major assets, while financial covenants set numerical targets such as a minimum cash balance.
For a non-finance manager, the practical point is that everyday decisions can affect these tests. Buying equipment on credit raises debt, and a poor sales month lowers profit.
Either can push a ratio towards its limit. If the borrower breaks a covenant, the lender may have the right to demand repayment immediately, raise the interest rate or ask for extra security.
In practice, lenders often agree a waiver, which is a one-off permission to ignore the breach, or amend the terms, especially when the borrower raises the issue early. Think of loan covenants as the rules of a board game.
Just like players must follow the rules to keep the game fair and enjoyable, borrowers must follow covenants to keep the loan agreement fair and safe for the lender.
In practice
Real-world examples
Example 1
An entrepreneur takes out a $200,000 loan to open a new cafe. The bank includes a covenant that requires the cafe to keep at least $20,000 in its bank account at all times. If the balance falls below this level, the entrepreneur must meet with the bank to discuss the business plan.
Example 2
A small manufacturing company takes a $500,000 loan to buy new equipment. The loan covenant requires the company to keep its debt-to-equity ratio below 2.0. With debt of $300,000 and equity of $200,000 the ratio is 1.5, so the company passes, but it must balance how much it borrows against how much it owns.
Example 3
A family-owned logistics firm borrows $150,000 for new vans. The agreement includes a covenant that it must send the bank audited accounts within 90 days of each year end. Missing the deadline would be a breach even if the business is making a healthy profit.
Think of it
Think of loan covenants as the rules of a board game. Just like players must follow the rules to keep the game fair and enjoyable, borrowers must follow covenants to keep the loan agreement fair and safe for the lender.
Formula
Calculation
Debt Service Coverage Ratio (DSCR) = Operating Profit / Annual Debt Service (principal plus interest payments)
Worked example: a cafe has an operating profit of $90,000 and annual loan payments of $50,000, so DSCR = $90,000 / $50,000 = 1.8. If the covenant requires a minimum DSCR of 1.5, the cafe passes.
The headroom is worth knowing. To stay at 1.5, operating profit must stay above $50,000 x 1.5 = $75,000. That leaves a cushion of $90,000 - $75,000 = $15,000, so profit can fall by about 17% ($15,000 / $90,000) before the covenant is breached.Case study
Seen in the real world
This is a fictional, illustrative scenario. Daybreak Coffee, a small chain of three cafes, borrowed $200,000 to open a fourth site. The loan agreement carried a covenant requiring a DSCR of at least 1.5, based on annual debt payments of $50,000, which meant operating profit had to stay above $75,000. In the first year, operating profit was $90,000, a DSCR of 1.8, and the covenant was met comfortably.
In the second year, a rent increase cut operating profit to $70,000, a DSCR of $70,000 / $50,000 = 1.4, which was below the 1.5 minimum. The finance manager noticed the problem before the bank's review and called the lender with a plan to renegotiate supplier prices and trim opening hours at quiet sites. Because Daybreak raised the issue early, the bank agreed to lower the covenant to 1.3 for twelve months in return for a small fee, and no default was declared.
Watch out
Common mistakes
- Signing a loan agreement without reading the covenants buried in the fine print.
- Assuming that a profitable business can never breach a covenant, when cash balance or debt ratio tests can fail in a profitable year.
- Hiding a likely breach from the lender instead of speaking to the bank early.
Questions
People also ask
What is the difference between a financial and a non-financial covenant?
A financial covenant is a numerical test, such as a minimum DSCR or cash balance, while a non-financial covenant is a rule about actions, such as sending reports or not selling key assets.
What happens if I break a covenant?
The lender may be able to demand immediate repayment, raise your interest rate or charge a waiver fee. Many lenders will negotiate a waiver or amendment if you tell them early.
Can covenants be changed after the loan is signed?
Yes, by agreement. The lender may ask for a fee or a higher interest rate in return for relaxing a covenant.