A financial covenant is a metric or condition in the loan agreement that the company must maintain for the duration of the loan. The bank typically tests them quarterly based on the latest reporting. When a covenant is breached, it triggers a technical default that gives the bank the right to intervene—even if payments are current.
The most common financial covenants
1. Leverage / Gearing limit
Total debt (or net debt) must not exceed a multiple of EBITDA. Typically between 3.0× and 4.5× for SMEs.
2. Interest Coverage
Operating earnings must cover interest expenses by a specified factor. Typically 3.0× to 5.0×.
3. Debt Service Coverage (DSCR)
Cash flow must be able to cover both interest and principal payments. Typically 1.2× to 1.5×.
4. Minimum equity / Solvency
Equity must not fall below a percentage of total assets, or an absolute threshold.
5. Capex restriction
Annual capital expenditure must not exceed a fixed ceiling without the bank's prior consent.
Worth knowing: Beyond financial covenants, loan agreements also contain affirmative covenants (what you must do—e.g., deliver reports on time) and negative covenants (what you must not do—e.g., sell material assets without consent).
Why do financial covenants exist?
The bank lends to a company in one financial state. That state can deteriorate. Financial covenants enable the bank to detect deterioration early—before it becomes a payment default. When a covenant is breached, the bank can intervene while there are still assets and headroom to negotiate.
Where do I find my covenants?
They typically appear in a dedicated section of the loan agreement, often labeled "Financial Undertakings" or "Financial Covenants". Have your advisor or CFO translate the definitions into concrete metrics—this is where many companies discover that their own calculations don't match the bank's test formulas.