Understanding Loan Covenants: Protecting Your Business Interests

What Are Loan Covenants—and Why Should You Care?

When you sign a business loan agreement, you’re agreeing to more than just repayment terms and interest rates. You’re also accepting a set of rules known as loan covenants—conditions your business must meet while the loan is active.

Understanding loan covenants is essential because they influence your day-to-day operations and long-term financial flexibility. Whether you’re applying for a small business loan or a multi-million dollar credit facility, being well-informed about covenants can help you avoid violations, maintain lender trust, and protect your business interests.

What Are Loan Covenants?

Loan covenants are stipulations set by a lender to reduce risk and ensure the borrower maintains financial health during the life of the loan. These covenants are legally binding and usually outlined in the loan agreement.

There are two main types:

• Affirmative covenants: Things you must do

• Negative covenants: Things you must not do

Failure to comply with covenants—even accidentally—can trigger a loan default, potentially leading to penalties, increased interest rates, or even loan acceleration.

Common Types of Loan Covenants

✅ Affirmative Covenants (What You Must Do)

These are proactive steps your business agrees to take, such as:

• Maintaining proper financial records

• Submitting regular financial statements

• Carrying adequate insurance

• Paying all taxes and legal obligations

• Complying with applicable laws and regulations

❌ Negative Covenants (What You Must Not Do)

These restrict certain actions that could increase risk for the lender:

• No taking on new debt without approval

• No selling major assets

• No major changes in business structure

• No issuing dividends beyond a set threshold

• No mergers or acquisitions without consent

📊 Financial Covenants

These are key metrics your business must meet to show ongoing financial stability:

• Debt Service Coverage Ratio (DSCR)

• Interest Coverage Ratio

• Minimum Net Worth

• Maximum Leverage Ratio

These are often monitored quarterly or annually.

Why Lenders Use Loan Covenants

Loan covenants help lenders:

• Monitor the borrower’s financial health

• Mitigate credit risk

• Detect early warning signs of trouble

• Maintain control over loan conditions

From the lender’s perspective, covenants are risk management tools that ensure your business remains capable of repaying the loan.

How Loan Covenants Impact Your Business

1. Greater Accountability

Covenants require consistent tracking of financial performance, promoting transparency and fiscal discipline.

2. Operational Constraints

Restrictions on spending, hiring, or expansion can limit your strategic options.

3. Risk of Default

Even unintentional covenant breaches can trigger serious consequences like penalties or loan recall.

4. Stronger Financial Planning

Meeting financial covenants encourages proactive cash flow and budget management.

Featured Snippet: What Is a Loan Covenant?

A loan covenant is a set of terms and conditions in a loan agreement that the borrower must follow. These can include financial metrics, operational rules, and reporting requirements. Covenants are designed to protect the lender and ensure the borrower remains financially sound during the loan period.

Negotiating Loan Covenants: What You Can Ask For

Just like interest rates or loan amounts, covenants are negotiable—especially if your business is financially healthy.

Tips for Negotiating Covenants:

• Request reasonable financial thresholds based on your historic performance

• Push for cure periods (grace time to fix a breach)

• Limit restrictions on operational changes that may impact growth

• Clarify definitions (e.g., how “EBITDA” or “default” is calculated)

• Discuss what happens in the event of a breach

What Happens If You Break a Covenant?

A covenant breach doesn't automatically mean your loan will be terminated, but it does give the lender certain rights. Here’s what typically happens:

1. Notification – You’ll be required to inform the lender of the breach.

2. Remedy Period – Some loans provide a grace period to correct the issue.

3. Lender Action – If not resolved, the lender may:

   • Increase interest rates

   • Request additional collateral

   • Restrict access to additional funds

   • Declare default and demand immediate repayment

Always read the fine print to understand your options in the event of a default.

How to Stay Compliant with Loan Covenants

Here are practical strategies to avoid breaching covenants:

• Set up automated alerts to monitor key financial ratios

• Use cloud-based accounting software to ensure real-time visibility

• Regularly review your covenant checklist

• Maintain open communication with your lender

• Plan for the unexpected—build buffer room into your ratios

Summary: Know Your Covenants Before You Sign

Loan covenants can be a hidden risk—or a safeguard—depending on how well you understand and manage them. They’re there to protect the lender, but staying compliant helps protect your business too.

By taking time to understand the types, terms, and implications of loan covenants, you’ll avoid costly mistakes and maintain better control of your finances.

Considering a business loan?
Talk to one of our lending advisors today for a free consultation. We’ll help you evaluate potential loan terms, including covenants, so you can make a confident, informed decision. Don’t sign anything until you fully understand what’s in the fine print.