Understanding loan covenants

Loans are built on trust and depend on loan covenants—predefined guidelines and progress updates—to maintain your lender’s confidence.

Covenants are the guardrails of a loan, providing both parties with a clear understanding of what’s expected from one another and a means of communication. Through a loan covenant, your company promises to stay financially sound, while your lender lays out expectations for financial measures that will help ensure repayment.

Before you take out a loan, learn the basics about covenants.

What is a loan covenant?

When a lender extends a line of credit to a borrower, the two parties are bound by a legal contract known as a credit agreement or a loan contract. There are stipulations—or covenants—within the agreement that dictate what a borrower can (affirmative covenants) and cannot (negative covenants) do during the life of the loan.

If a borrower fails to abide by a loan covenant, it’s considered a covenant violation or a covenant breach. As a result, the lender may terminate the agreement, impose penalties, or accelerate the loan’s repayment schedule.

Covenants benefit your business—and your lender.

Loan covenants ensure that a borrower’s financial performance supports the profitability and cash flow needed to repay the loan. They serve as risk management safeguards for the lender, but they also promote a company’s overall financial health.

For instance, some covenants require businesses to take specific steps, like maintaining a certain debt-service coverage ratio (DSCR), providing audited financial statements, and keeping accurate accounting. Others may outline expectations for specific actions, such as limiting the issuing of dividends to shareholders or restricting the amount of debt a company can carry.

Some businesses may find covenants too restrictive, with the risk of violation hindering their economic freedom. But operating under covenants can actually reduce the cost of the loan, since you’re agreeing to operate under the lender’s repayment conditions and they may offer favorable terms in return.

What kinds of loan covenants are there?

Quantitative covenants set standards for financial measures—such as your cash flow, your debt level, and the strength of your business—that give your lender confidence in your company’s ability to repay a loan. Typical measures include debt-to-equity, cash-to-assets, and interest coverage ratios.

Qualitative covenants specify information that your company must provide, like quarterly financial statements or tax reports. These covenants also restrict actions your business can take, like taking on more debt or selling assets without your lender’s consent.

Standard loan covenants outline criteria that are part and parcel of lending but still must be stipulated in the credit agreement to be legally enforceable. An example would be requiring the borrower to pay the principal and interest on specific due dates.

Nonstandard loan covenants are typical in commercial lending, and they address characteristics related to the borrower. They include requiring the borrower to supply accounts receivable lists or monthly compliance certificates.

Financial loan covenants ensure that a borrower maintains adequate financial health to repay the loan. They may restrict financial decisions, like debt-to-equity ratios or maximum capital expenditure requirements.

Nonfinancial loan covenants protect a lender’s interest beyond financial health. They may restrict a company’s ability to transact a mergers and acquisitions (M&A) deal or to change business leadership.

Think of your loan covenants as an early warning system and a clear statement of your lender’s expectations.

Stay in communication with your lender to avoid a covenant breach.

Loan covenants are typically monitored quarterly to reduce the burden of oversight. Failure to comply with a covenant could result in penalties or your lender’s calling your loan in default.

Sometimes there are justifiable reasons for breaching a loan covenant. For example, unexpected events, like a sudden rise in material expenses while your business is recovering from a natural disaster, may cause you to violate a covenant. Or rapid growth may cause your company to violate a cash-to-assets ratio loan covenant, especially if profits are used to buy inventory, hire workers, and extend credit to new customers.

Lenders are usually flexible in these situations, particularly if you show that you are managing the situation well or are building a stronger business. Speak with your lender if you’re at risk of breaching a covenant. Ask for advice and keep your lender updated until you’re back in compliance.

Think of your loan covenants as an early warning system and a clear statement of your lender’s expectations. Structured properly and followed closely, loan covenants can help you avoid payment problems and help ensure a smooth and timely debt repayment.