Loan Covenants in Commercial Lending

“Play it clean or face the Scene”

Loan Covenants: Guiding Borrowers, Protecting Lenders

Loan covenants are legally binding conditions included in a loan agreement.

They are designed to help lenders manage risk while encouraging borrowers to maintain financial discipline. These covenants serve as early warning indicators of financial distress and ensure that borrowers operate within agreed parameters throughout the life of the loan. 

The three primary loan covenant types are:  Financial, Affirmative, and Negative.

Financial Covenants

Financial covenants require the borrower to maintain specific financial metrics that reflect their ability to meet debt obligations and maintain solvency. These are often tested quarterly or annually, depending on the agreement.

Common financial covenants include:

  • Debt Service Coverage Ratio (DSCR):
    Measures the borrower’s ability to service debt from operating income.
    Example: The borrower must maintain a DSCR of at least 1.25, meaning net operating income must be at least 1.25 times total debt service.

  • Leverage Ratio (e.g., Debt/EBITDA):
    Limits the borrower’s total debt relative to earnings before interest, taxes, depreciation, and amortization.
    Purpose: Ensures the borrower doesn’t become over-leveraged.

  • Minimum Net Worth or Liquidity:
    Requires the borrower to maintain a minimum level of net assets or cash reserves.
    Purpose: Helps ensure the borrower can absorb losses or meet short-term obligations.

Affirmative Covenants

These are proactive obligations—things the borrower is required to do.
They promote transparency and operational soundness.

Typical affirmative covenants include:

  • Providing regular financial statements (e.g., quarterly and annual reports)

  • Maintaining adequate insurance coverage

  • Paying taxes and other obligations on time

  • Complying with all applicable laws and regulations

Negative Covenants

Negative covenants restrict certain borrower actions unless the lender provides prior written consent. These limitations are in place to prevent changes that could jeopardize the borrower’s ability to repay the loan.

Examples of negative covenants:

  • No additional debt: Prevents the borrower from taking on new loans that could strain cash flow.

  • Restrictions on dividends or equity repurchases: Preserves capital within the business.

  • Asset sales limitations: Prevents the borrower from selling key assets that generate revenue or serve as collateral.

Covenant Violations and Defaults

Importantly, a covenant breach can trigger a technical default, even if the borrower is current on all loan payments. In such cases, the lender may have the right to:

  • Accelerate the loan (demand immediate repayment)

  • Increase the interest rate (default rate)

  • Require corrective actions

  • Call in additional collateral or guarantees


Why Covenants Matter

Covenants are not just about protecting lenders—they help borrowers stay financially healthy and aligned with long-term goals. Understanding and managing these obligations proactively is essential to maintaining a strong lender relationship and avoiding unintended defaults.

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Best Practices when deliberating Loan Covenants

Know What You’re Signing

Before agreeing to any loan, understand what covenants are included and how they work:

  • Financial covenants: Know what metrics (e.g., DSCR, leverage) you’re being held to.
  • Affirmative covenants: Understand your ongoing obligations.
  • Negative covenants: Recognize what actions you’ll need lender approval for.

Tip: Have your CFO or accountant model your current and forecasted compliance before signing.

Negotiate What’s Reasonable

Covenants are negotiable—don’t assume they’re fixed. Push for terms that reflect your business’s realities.

  • Request grace periods or cure rights for breaches.
  • Avoid overly tight metrics that leave no margin for fluctuation.
  • Seek to cap restrictions like dividend payments or additional debt.

Tip: Back up your negotiation with historical performance and industry benchmarks.

Ensure Internal Monitoring Systems Are in Place

Set up internal tracking to monitor covenant compliance.

  • Use KPIs and dashboards to track DSCR, leverage, and net worth.
  • Assign responsibility—your controller or CFO should “own” covenant reporting.

Tip: Automate alerts if thresholds are nearing breach territory.

Understand the Consequences of a Breach

Even technical defaults can have major implications:

  • Triggering higher interest rates
  • Early repayment clauses
  • Damaged lender relationships or credit score impact

Tip: Ask lenders up front how breaches will be handled—some may offer forbearance periods or waivers.

Stay Proactive with Communication

If you anticipate a breach:

  • Inform your lender early
  • Present a plan to remedy or mitigate
  • Request a waiver in writing if needed

Tip: Most lenders value transparency and will work with you if they feel informed and respected.

Align Covenants with Business Strategy

If you’re planning major moves—acquisitions, asset sales, expansions—make sure your covenants won’t block or delay you.

Tip: Include language that allows flexibility for strategic initiatives with reasonable notice.

Involve Advisors

Work with:

  • A commercial banker who understands your industry
  • Legal counsel for document review
  • Your CPA or fractional CFO for compliance and financial planning

Summary

Loan covenants are more than checkboxes—they’re operational guardrails and risk signals. Business owners should treat them as tools to ensure mutual clarity between borrower and lender. The key is negotiation, transparency, and ongoing discipline.