Finance director reviewing bank loan covenant terms

Bank loan covenants are the contractual conditions attached to a facility agreement that oblige a borrower to hit certain financial ratios or refrain from specific actions, and breaching one can trigger an event of default even without missing a single repayment. Before signing anything, check three things: how each ratio is defined, how often it gets tested, and what cure rights exist if you slip. Get those wrong, and a covenant becomes a trap rather than a safeguard.

TL;DR:

Most breaches of loan covenants occur due to misdefined ratios or outdated accounting treatments, especially IFRS 16 lease liabilities, rather than missed payments.

Borrowers should negotiate clear definitions, realistic headroom, and specific remedy rights before signing to prevent covenants from becoming traps.

Regularly modeling covenant positions and early disclosure of potential breaches greatly improves chances of securing waivers or amendments without enforcement.

Enforcement options include waivers, amendments, standstills, or formal actions, but lenders prefer forbearance supported by strong early communication and demonstrated viability.

Maintaining accurate, up-to-date financial modeling and proactive covenant management helps avoid surprises and reduces the risk of forced default actions.

What are bank loan covenants?
What types of loan covenants will you actually see?
What do the common financial covenant ratios actually mean?
How are covenants tested, and where do accounting rules trip people up?
What happens if you breach a bank loan covenant?
What should you do if a breach is coming?
How do you negotiate covenant terms before you sign?
Where fractional CFO support fits into covenant negotiation
What people underestimate about covenant risk
Sources
FAQ

What are bank loan covenants?

Covenants are contractual, not statutory. Nothing in law forces a business to accept them. A lender negotiates them into the loan agreement to protect its position, and once signed they carry the same legal weight as the repayment schedule itself. This is a point LexisNexis’s glossary makes clearly: financial covenants mandate adherence to quantitative metrics such as net debt/EBITDA and interest cover, while positive and negative covenants govern behaviour.

The taxonomy splits into a few overlapping categories:

Positive (affirmative) covenants require action: maintain insurance, deliver management accounts, keep the business properly licensed.
Negative covenants restrict action: no new borrowing, no asset disposals, no dividends above an agreed cap without consent.
Financial covenants test ratios against a threshold, typically quarterly.
Non-financial covenants cover reporting, insurance, and compliance with law.
Maintenance covenants are tested on a rolling basis throughout the loan’s life.
Incurrence covenants are only tested when a borrower takes a specific action, such as raising further debt.

None of this works without precise definitions. How EBITDA is calculated, which add-backs are permitted, and how IFRS 16 lease liabilities are treated inside the ratios can swing a covenant test from comfortable headroom to technical breach. That is where most disputes actually start.

What types of loan covenants will you actually see?

Facility agreements tend to layer several covenant types together, each doing a different job.

Financial ratio covenants are the headline numbers: leverage, interest cover, debt service cover. Lenders pick the combination based on loan type and security, and property or asset-based facilities often add a loan-to-value test that pure cashflow lending would not include, a point worth understanding if you’re weighing up asset-based lending as a funding route.

Information and reporting covenants oblige the borrower to deliver management accounts, budgets, and a compliance certificate on a set schedule. This is the mechanical backbone of the whole covenant regime. Without timely reporting, a lender has no way of knowing whether the financial covenants are being met at all.

Negative or consent covenants restrict specific actions without lender approval:

Taking on additional debt beyond an agreed basket.
Disposing of material assets.
Paying dividends or distributions above a set cap.
A change of control or ownership structure.

Security and guarantor cover tests confirm that the assets and guarantees backing the loan still provide adequate cover, particularly relevant where a business has multiple group entities and the lender wants cross-guarantees maintained. Understanding what lenders actually check before approval helps here, and it overlaps heavily with the checks lenders run on SME debt finance.

What do the common financial covenant ratios actually mean?

Four ratios dominate UK facility agreements, and each answers a different question about the business.

Net debt/EBITDA measures leverage: how many years of earnings it would take to clear net debt. A covenant might set this at a leverage ratio typical for similarly structured loans, tightening over the life of the loan as the lender expects deleveraging. Breach this and the lender starts asking whether the growth plan behind the borrowing still stacks up.

Interest cover (EBITDA divided by interest expense) shows how comfortably a business services its debt costs. As base rates have moved in recent years, interest cover ratios that looked safe at origination have come under real pressure purely from the cost of money rising, without revenue changing at all.

Debt service cover ratio (DSCR) goes further than interest cover by including capital repayments, not just interest, which makes it the sharper test for businesses with amortising facilities. Loan-to-value (LTV) applies mainly to asset and property-backed lending, comparing outstanding debt against the current value of the secured asset.

Minimum liquidity and net worth checks round out the set, acting as early warning triggers before leverage or cover ratios deteriorate. LexisNexis’s introductory guide confirms these five (leverage, interest cover, LTV, DSCR and minimum liquidity) as the standard checks lenders reach for depending on facility type and security.

Pro Tip: Build a headroom buffer, not just a pass/fail model. If the downside case breaches, negotiate a higher threshold now rather than a waiver later.

How are covenants tested, and where do accounting rules trip people up?

Maintenance covenants are tested on a fixed cycle, usually quarterly, using trailing 12-month figures rather than a single period in isolation. Incurrence covenants only get tested at the moment of a triggering event, such as drawing further debt, which is why they suit revolving facilities better than term loans with a stable maintenance test.

The mechanics matter more than most borrowers expect:

Reporting window: compliance certificates are typically due within a month or so after the test date, delivered alongside management accounts.
Rolling versus period tests: a rolling last-twelve-months (LTM) calculation smooths one bad quarter but also carries a weak quarter forward for a full year.
Accounting treatment: IFRS 16 brings lease liabilities onto the balance sheet, which can inflate net debt and distort leverage covenants unless the facility agreement explicitly carves out lease accounting from the definition, a point the LMA’s term sheet completeness guidance flags directly.
Forecast breaches: if management accounts already point to a breach ahead of the formal test date, early disclosure to the lender is expected, and often required under the facility’s own terms.

Here is the point most borrowers miss: a delayed compliance certificate does not delay the breach itself. If the underlying accounts already show non-compliance, CMS’s briefing on impending financial covenant breach is clear that the contractual breach exists regardless of when the certificate is filed. Relying on a slow reporting process to buy time is not a strategy.

What happens if you breach a bank loan covenant?

A covenant breach is not the same as missing a repayment, but it carries similar legal weight. A technical breach, say leverage creeping to 3.6x against a 3.5x covenant, still constitutes an Event of Default under most facility agreements, even if every payment has been made on time. What happens next depends entirely on how the lender chooses to respond.

Lenders generally have several options, and enforcement is rarely the first move:

Waiver: the lender agrees to overlook the breach, usually for a single test period, often attaching conditions.
Amendment or reset: the covenant threshold is renegotiated going forward, sometimes with a fee.
Standstill: the lender agrees not to act for a defined period while a longer-term fix is worked out.
Formal enforcement: acceleration of the loan, appointment of a receiver, or enforcement of a debenture over secured assets.

The Bank of England’s analysis of SME forbearance makes an important point: lenders will often support a viable business through forbearance rather than enforce, but a waiver is conditional, never an entitlement. Expect enhanced reporting, additional security, or a margin step-up as the price of leniency. For secured lending, the practical risk sits with the directors as much as the business. Persistent breaches without a credible remedy plan can shift attention onto directors’ duties, particularly around wrongful trading, if insolvency starts to look likely.

What should you do if a breach is coming?

The single biggest mistake is silence. Lenders respond far better to a business that flags a problem early with numbers attached than one that waits for the compliance certificate to force the conversation.

Recalculate accurately. Run the exact covenant formula from the facility agreement, not an approximation, and build a downside sensitivity case around it.
Talk to the lender before the test date. Bring the numbers, not just the concern. Lenders are far more receptive to a business that has already diagnosed the problem.
Propose a waiver or amendment plan. Set out what changed, why, and what the business will do differently, with a revised threshold or timeline attached.
Prepare a contingency. An equity cure, a refinancing option, or an asset sale should be quantified in advance, not sketched out mid-negotiation.
Get any concession in writing, following the amendment mechanics set out in the facility agreement itself, never on the strength of a verbal assurance.
Bring in advisers early, particularly legal counsel and a finance professional who can build the model the lender will want to see.

Pro Tip: Lenders often prefer a temporary standstill that keeps information flowing over immediate enforcement. Offering enhanced reporting voluntarily, before it’s demanded, tends to buy more goodwill than resisting it.

How do you negotiate covenant terms before you sign?

The best time to fix a covenant problem is before the facility agreement is signed, not after a breach.

Insist on fully drafted definitions for every ratio, including a worked example calculation, not just a formula in the abstract.
Ask for pro-forma opening ratios calculated on day one, so both sides agree the starting position before anything moves.
Negotiate realistic headroom, appropriate baskets for permitted debt and disposals, and carve-outs for genuinely one-off items.
Request equity cure rights or a covenant holiday for the first testing period, particularly around an acquisition or a major capital investment.
Push back on open-ended “material adverse change” language and uncapped or undefined EBITDA add-backs, both of which hand the lender interpretive discretion you will regret later.
If the facility includes sustainability-linked KPIs, get clarity on verification timelines and third-party verifier responsibilities, since the LMA’s guidance on Sustainability-Linked Loan Principles flags disputed KPI results as a real and growing source of friction.
Document the amendment and waiver mechanics clearly, including notice periods and who needs to consent.

Where fractional CFO support fits into covenant negotiation

Preparing a credible covenant position takes more than a spreadsheet knocked together the week before signing. A fractional CFO builds the investor-grade model a lender expects to see: pro-forma opening ratios, sensitivity-tested headroom, and a compliance certificate template that matches the facility’s exact wording rather than a rough approximation.

That same rigour matters just as much after signing, when a business needs to put together a waiver proposal or renegotiate a threshold. Consult EFC’s fractional CFO services are built around exactly this kind of lender-facing work, drawing on ICAEW-standard financial modelling to give founders the numbers and the narrative a lender needs before it will agree to flex. Where the underlying issue is structural rather than temporary, investor-grade financial modelling can also underpin a refinancing conversation, giving a business options beyond simply asking its existing lender for patience.

What people underestimate about covenant risk

Most guidance on covenants treats them as a compliance exercise: hit the ratio, file the certificate, move on. That undersells what is actually happening. A covenant is the lender’s early warning system, built to trigger before a business runs out of cash, not after. Treating it purely as a box to tick misses the point entirely, and it is exactly why so many businesses get caught out by a breach they could have seen coming three months earlier if the model had been stress-tested properly.

The gap that consistently catches businesses out is definitional, not financial. Two businesses with identical underlying performance can land on opposite sides of a covenant test purely because one negotiated a clean IFRS 16 carve-out at signing and the other did not. That is not bad luck. It is the direct result of not pushing hard enough on drafting when there was still leverage to do so, at term sheet stage, before the ink dried.

If there is one habit worth building, it is this: model the covenant position quarterly, whether the lender demands it or not, and treat a shrinking headroom as the trigger for a conversation, not the breach itself. By the time the compliance certificate shows a problem, the best options, an equity cure, a covenant reset, an early refinancing, have usually narrowed considerably.

— Kishen Patel

Sources

FAQ

What are typical loan covenants?

Typical covenants combine financial ratio tests, such as net debt/EBITDA and interest cover, with information covenants requiring regular management accounts and a compliance certificate. Negative covenants restricting new debt, disposals, and dividends usually sit alongside them.

What are the three main types of debt covenants?

The three broad categories are positive (affirmative) covenants requiring specific action, negative covenants restricting certain actions without lender consent, and financial covenants testing quantitative ratios like leverage or interest cover. Facility agreements typically combine all three rather than relying on just one type.

What are the three types of covenants?

Beyond the positive, negative and financial split, covenants are also commonly grouped by testing method: maintenance covenants tested on a rolling basis, and incurrence covenants triggered only by a specific action such as raising new debt. Which structure applies depends on the facility type and how the lender wants to monitor risk.

Can you give me an example of a financial covenant?

A common example is a net debt to EBITDA covenant set at, say, 3.5x, meaning net debt cannot exceed three and a half times annual earnings before interest, tax, depreciation and amortisation. Another frequent example is an interest cover ratio requiring EBITDA to exceed interest costs by a set multiple, both tested quarterly using trailing 12-month figures.

3 Bank Loan Covenant Checks Before Signing

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