loan covenants explained — business owner reviewing financial agreement

Loan Covenants Explained: 8 Important Key Terms Every Business Owner Must Know

If you’ve ever signed a commercial loan agreement, you’ve likely come across pages of conditions and ratios that seem written in another language. These are called loan covenants—and misunderstanding them can cost your business. In this article, we’ll provide loan covenants explained in simple, practical terms, so you know exactly what lenders expect and how to stay compliant.

What Are Loan Covenants?

At their core, covenants are rules in your loan agreement. They protect the lender by ensuring your business maintains financial health and operates responsibly.

  • Positive covenants (things you must do): e.g., provide audited financials, maintain insurance.
  • Negative covenants (things you can’t do): e.g., no additional debt without consent.
  • Financial covenants (ratios and thresholds): e.g., maintain Debt Service Coverage Ratio (DSCR) ≥ 1.20x.

When reviewing loan covenants explained, remember that breaching them—even unintentionally—can trigger default, penalties, or loan acceleration.

Loan Covenants Explained: 8 Key Terms

1) Debt Service Coverage Ratio (DSCR)

Measures your ability to cover debt payments with cash flow.

  • Formula: Net Operating Income ÷ Total Debt Service
  • Example: A DSCR of 1.25x means you generate $1.25 for every $1 owed in loan payments.

2) Leverage Ratio

Compares total debt to equity or EBITDA.

  • Common covenant: Debt ÷ EBITDA ≤ 3.5x
  • High leverage signals risk to lenders.

3) Minimum Net Worth

Requires owners to maintain a set equity base. Falling below it may signal financial instability.

4) Liquidity Ratio (Current or Quick Ratio)

  • Current Ratio: Current Assets ÷ Current Liabilities
  • Lenders may require ≥ 1.2x to ensure you can cover short-term obligations.

5) Borrowing Base Covenant

Applies to lines of credit. Limits borrowing based on eligible collateral (e.g., 80% of receivables under 90 days).

6) Reporting Requirements

Mandates timely submission of financial statements, tax returns, and compliance certificates.

7) Restrictions on Additional Debt

Prohibits or limits taking on new loans without lender approval, protecting the lender’s repayment priority.

8) Dividend or Distribution Limits

Restricts payouts to shareholders while debt is outstanding, ensuring cash stays in the business.

Why Covenants Matter

  • Early warning system: Signals problems before default.
  • Negotiation leverage: Strong borrowers can negotiate lighter terms.
  • Relationship factor: Transparent communication with lenders builds trust.

Understanding loan covenants explained can help you use them as tools, not traps.

Tips for Managing Loan Covenants

  1. Model compliance before signing: Run covenant ratios in your financial forecasts.
  2. Negotiate headroom: Build cushion into ratios (e.g., DSCR 1.35x instead of 1.20x).
  3. Track quarterly: Use dashboards to monitor in real-time.
  4. Communicate early: If you expect a breach, notify the lender proactively.
  5. Consider covenant-lite alternatives: Some private credit lenders offer more flexible terms—at a price.

U.S. vs. Canada Context

  • U.S.: Covenants are standard in SBA loans, ABL facilities, and private credit agreements. SBA loans often emphasize DSCR and liquidity tests.
  • Canada: Programs like the Canada Small Business Financing Program (CSBFP) have fewer ongoing covenants but private lenders and BDC often include DSCR and net worth requirements.

Cross-border companies should prepare for more rigorous U.S.-style covenant packages when borrowing internationally.

Don’t let hidden terms derail your financing. At Agile Solutions, we help businesses understand covenants, negotiate terms, and prepare compliance-ready financials.
👉 Book a consultation today at agilesolutions.global or email us at info@agilesolutions.global

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