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.
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.
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.
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
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
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.
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.
Covenants require consistent tracking of financial performance, promoting transparency and fiscal discipline.
Restrictions on spending, hiring, or expansion can limit your strategic options.
Even unintentional covenant breaches can trigger serious consequences like penalties or loan recall.
Meeting financial covenants encourages proactive cash flow and budget management.
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.
Just like interest rates or loan amounts, covenants are negotiable—especially if your business is financially healthy.
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
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:
Notification – You’ll be required to inform the lender of the breach.
Remedy Period – Some loans provide a grace period to correct the issue.
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.
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
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.