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Financial covenants
Financial covenants require the company to maintain specific ratios at testing dates, usually quarterly or annually. Common examples include:
- Interest cover ratio — EBITDA (or EBIT) divided by net finance charges must exceed a set multiple, e.g. 2.0x.
- Leverage ratio — total net debt divided by EBITDA must stay below a ceiling, e.g. 3.5x.
- Minimum net asset value — the company's net assets must not fall below an agreed floor.
- Loan-to-value — for property-backed lending, the outstanding debt as a proportion of property value must stay within a band.
All ratios are illustrative examples; actual covenant levels are negotiated and set per facility.
Non-financial covenants
Non-financial (or information) covenants govern the company's behaviour and disclosure obligations. Typical examples include: providing audited accounts within a set period; notifying the lender of material litigation, change of control, or asset disposals above a threshold; maintaining adequate insurance; and not creating further security over charged assets without consent. These are sometimes called 'affirmative' and 'negative' undertakings.
Consequences of breach
A covenant breach is a technical default, even if the company is continuing to make repayments on time. It gives the lender the right to accelerate the loan (demand immediate repayment in full) or enforce security, though in practice lenders often prefer to negotiate a waiver or amendment rather than call the loan. However, this is at the lender's discretion and is not guaranteed.
Managing covenant compliance
Directors should model covenant compliance as part of regular financial planning — particularly before taking on material capital expenditure, acquisitions, or significant dividend distributions that could affect key ratios. Many companies build a 'headroom' buffer into their targets. If a breach is anticipated, raising it with the lender early — before the test date — typically results in a better outcome than a surprise notification after breach has occurred.
Frequently asked questions
What is a covenant waiver?
A waiver is a formal written agreement from the lender to overlook a specific breach for a defined period or testing date, without terminating or accelerating the facility. Waivers normally come with conditions and may require an amendment fee.
Can covenants be renegotiated during the loan term?
Yes, covenant terms can be amended by mutual agreement, documented in a formal deed of amendment. Lenders will re-underwrite the position and may require additional security, fees, or tightening of other terms in exchange.
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