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Financial covenants and how they are calculated
Financial covenants are quantitative tests applied to the company's financial statements at agreed intervals — usually quarterly or annually. The most common are: a leverage ratio (net debt divided by EBITDA, typically capped at 3x–4x); a DSCR test (as described in the affordability guide, typically floored at 1.25x); a minimum net worth or tangible net assets test; and sometimes a maximum capex covenant to prevent the company over-investing without lender approval.
The specific thresholds and definitions — how EBITDA is calculated, what counts as net debt, whether tested on a trailing twelve-month or rolling period — are negotiated and set out in the facility agreement. Directors should ensure they have a clear understanding of the definitions before signing, because the accounting policy choices a company makes can have a material effect on whether covenants are met.
Operational and information covenants
Operational covenants restrict the company's behaviour during the facility term. Common examples include: no disposal of material assets above a defined threshold without consent; no change of control of the company without notice or consent; no granting of further security; and no material change in the nature of the business. These covenants protect the lender's assumptions about the risk profile of the business.
Information covenants require the company to deliver financial statements, management accounts, and compliance certificates on a defined timetable. Failure to provide information on time is itself a technical breach of the facility agreement, even if all financial tests are passing. Directors should calendar all information delivery obligations at the outset of the facility.
Breach, cure periods, and waivers
A covenant breach is an event of default under most facility agreements, but it does not automatically trigger immediate repayment. Most agreements include a cure period — typically 20 to 30 days — during which the borrower can remedy the breach. Remedies might include injecting additional equity to restore a net worth test, repaying part of the debt to improve a leverage ratio, or providing additional security to obtain a waiver.
If the breach cannot be cured, the borrower should approach the lender immediately and request a waiver letter — a formal written confirmation that the lender will not exercise its default remedies in respect of the specific breach. Waivers are time-limited and typically conditional on the borrower meeting revised targets. A pattern of repeated waivers will damage the lending relationship and may prompt the lender to seek to restructure or exit the facility.
Frequently asked questions
What is a covenant headroom analysis?
A headroom analysis models how far financial results can deteriorate before each covenant is breached. It is typically prepared by the company's finance team or advisers at each testing date and shared proactively with the lender. Maintaining visible headroom demonstrates good financial management and gives both parties early warning if trading deteriorates.
Are covenants negotiable?
Yes, within limits. Larger and better-quality borrowers typically have more negotiating leverage over covenant levels and definitions. At the time of application, directors should model their projected financial performance against the proposed covenant thresholds and request adjustments where there is a realistic risk of breach under base-case assumptions.
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