Loan covenants explained: what you are agreeing to monitor

What covenants are for

Covenants are conditions written into a loan agreement that the borrower must continue to meet for the life of the facility, separate from the obligation simply to make repayments on time. They exist because a lender's credit decision is based on the business as it looks at the point of lending, and covenants give the lender an early warning if the business drifts materially away from that picture before the situation becomes a full default.

They fall broadly into two categories: financial covenants, which are numerical tests measured periodically, and non-financial or general covenants, which are ongoing obligations such as providing management accounts, maintaining insurance, or not taking on further borrowing without consent.

Common financial covenants

The most common financial covenants in commercial lending are interest cover, which measures earnings against interest payable, debt service cover, which measures earnings against total debt repayments including capital, leverage or gearing ratios comparing debt to earnings or equity, and minimum tangible net worth. For property finance, loan to value is monitored on an ongoing basis, and a fall in property value can trigger a breach even where repayments are up to date.

Typical thresholds vary by sector and lender but debt service cover of around 1.25 times is a common minimum requirement, meaning earnings need to cover repayments with 25% headroom. Businesses should model these ratios against their own forecast before agreeing to a covenant level, since agreeing to a tight covenant to get a facility approved often creates an avoidable breach a year later.

Non-financial covenants and reporting

Non-financial covenants typically include providing annual accounts within a set period of year end, monthly or quarterly management accounts, maintaining adequate insurance, notifying the lender of any material litigation or change of ownership, and restrictions on paying dividends or taking on further debt without consent. These are usually straightforward to comply with but are also the most commonly missed, simply because businesses forget a reporting deadline rather than because of any underlying financial problem.

A technical breach caused by late reporting is treated very differently from a breach caused by deteriorating financial performance, but both are technically defaults under most agreements, so it is worth setting internal reminders for reporting deadlines rather than assuming a lender will chase.

What happens on a breach

Most lenders do not call in a facility at the first sign of a covenant breach, particularly a minor or technical one. The usual first step is a conversation, often followed by a formal waiver request, sometimes accompanied by a fee, or a reset of the covenant level to reflect current trading. Persistent or serious breaches, particularly ones linked to declining trading performance, are treated more seriously and can lead to increased monitoring, additional security requests, or in the worst case a demand for repayment.

The key practical point is to flag a likely breach to the lender before it happens rather than after, since lenders respond far better to advance notice and a credible recovery plan than to silence followed by a missed test.

Negotiating covenant headroom

Before accepting a facility, model the proposed covenants against a realistic downside scenario, not just the base case forecast, and push for headroom that survives a reasonable dip in trading. It is also worth negotiating a cure period, which allows a short window to remedy a breach before it is formally treated as a default, and agreeing covenant levels that step in line with the business's growth plan rather than being fixed at a single level for the whole term.