Loan covenants explained

What a covenant is

A covenant is a promise written into a loan agreement that the borrower will do — or refrain from doing — certain things for as long as the loan is outstanding. Covenants let a lender keep tabs on the company's health after the money has gone out, and act early if the position deteriorates, rather than only finding out when a payment is missed.

They are common on larger or longer-term secured facilities and far less so on short-term unsecured lending. Covenants are not penalties; they are conditions. But breaking one can have serious consequences, so a borrower needs to understand exactly what they are signing up to maintain.

Financial covenants and their ratios

Financial covenants require the company to keep specific numbers within agreed limits, tested at regular intervals. The most common are built on ratios the lender uses to gauge affordability and risk. Typical examples include:

• Debt service coverage ratio — earnings must cover debt repayments by a set multiple.
• Interest cover — profits must exceed interest by an agreed margin.
• Gearing or debt-to-equity — borrowing must stay below a ceiling relative to equity.
• Minimum net worth — the balance sheet must not fall below a floor.

These are tested against your management accounts, which is one reason lenders expect timely, accurate figures throughout the term, not just at application.

Non-financial covenants

Not every covenant is a number. Non-financial (or behavioural) covenants govern how the company conducts itself. Common ones require the borrower to provide accounts by a deadline, maintain insurance, keep the secured assets in good order, not take on further borrowing without consent, and not dispose of key assets or change the nature of the business.

These protect the lender's position in ways a ratio cannot. A company that quietly piles on new debt, lets its insurance lapse or sells the asset securing the loan changes the lender's risk even if its headline numbers still look fine — so the agreement forbids it. Breaching a non-financial covenant counts just as much as missing a ratio.

What happens if you breach one

A breach is technically an event of default, even if you have never missed a payment. That sounds alarming, but the practical response varies. A lender may waive the breach, agree a temporary relaxation, reset the covenant, or charge a fee — particularly for a one-off or minor slip flagged early. In more serious cases it can demand immediate repayment or enforce its security.

The golden rule is to talk to the lender before a breach, not after. Early, honest communication usually leads to a workable outcome; a surprise breach erodes trust. Covenants are far less common on short-term unsecured borrowing — Credicorp lends to limited companies on affordability without the heavy covenant packages of secured lending. This guide is educational and not financial advice.