Covenant

Q: What happens if I breach a covenant?

A breach is usually an event of default, even if repayments are current. The lender may waive it, renegotiate terms, add fees, or in serious cases demand early repayment. Telling your lender early, before they spot it, almost always leads to a better outcome.

2 min read

2 typesPositive & negative

BreachCan trigger default

Definition

A covenant is a contractual condition in a loan or finance agreement that the borrower agrees to meet while the debt is outstanding. Covenants protect the lender by setting boundaries on the borrower's behaviour and financial health. Breaching one can constitute an event of default, giving the lender rights such as demanding early repayment — even if every repayment so far has been made on time.

In plain terms

Covenants are the rules of the deal beyond simply paying on time. They come in three broad kinds. Positive (affirmative) covenants say what you must do — for example, supply management accounts each quarter or maintain insurance. Negative covenants say what you must not do — such as take on further debt or sell a major asset without consent. Financial covenants set numerical targets you must keep within, like a minimum interest cover ratio or a cap on overall borrowing.

They aren't there to trip you up; they're early-warning lines that let a lender step in before a problem becomes a loss.

Why it matters to your business

Covenants shape how much freedom you keep after signing. Tight covenants can restrict everyday decisions — borrowing more, paying dividends, buying equipment — and a technical breach can put you in default even when cash is flowing fine. Before signing any facility, read the covenants as carefully as the rate.

Simpler, short-term facilities typically carry fewer and lighter covenants than large secured term loans. When you compare offers, weigh the ongoing conditions, not just the headline cost: a cheap loan with restrictive covenants can cost you more in lost flexibility than a slightly dearer one that leaves you free to run the business.

Example

A company takes a £300,000 term loan with a financial covenant requiring its interest cover (profit relative to interest owed) to stay above 2.5 times, tested quarterly. A slow quarter pushes the ratio to 2.2. No payment has been missed, but the covenant is breached — a technical default. The lender could demand repayment, but in practice negotiates a temporary waiver in exchange for tighter reporting. The episode shows why directors should monitor covenant ratios continuously, not just at the year end.

Frequently asked questions

What happens if I breach a covenant?

A breach is usually an event of default, even if repayments are current. The lender may waive it, renegotiate terms, add fees, or in serious cases demand early repayment. Telling your lender early, before they spot it, almost always leads to a better outcome.

What is a financial covenant?

A covenant expressed as a number you must keep within — for example a minimum interest cover ratio, a maximum gearing level, or a minimum cash balance. They are tested at set intervals using your management or statutory accounts.

Do all business loans have covenants?

No. Large or secured facilities tend to carry detailed covenants; smaller, short-term and unsecured facilities often carry few or none. Always check the agreement so you understand what conditions apply before you draw down.