A Covenant Compliance Certificate functions as a formal confirmation from a borrower to a lender that all promises, or “covenants,” specified in a loan agreement are being met. These covenants are conditions set by lenders to protect their investment by ensuring the borrower maintains financial health and responsible behavior throughout the loan.
Covenants fall into three main categories:
- Financial Covenants: Numerical conditions such as maintaining a specific debt-to-equity ratio or a minimum debt service coverage ratio (DSCR).
- Affirmative Covenants: Obligations the borrower must fulfill, like providing regular financial statements or maintaining insurance.
- Negative Covenants: Restrictions on certain actions, such as not incurring additional debt without lender consent or selling major assets.
The certificate is usually prepared by a senior financial officer, such as the CFO, who certifies the borrower’s compliance based on accurate financial data. The document includes details of the loan, the reporting period, a list of covenants, calculated compliance status for each, and supporting financial statements.
For example, a company might have a covenant requiring a DSCR of at least 1.25x. The certificate would show the actual DSCR for the reporting period and state whether the company complied. If non-compliance occurs, lenders may invoke default provisions, leading to renegotiations, penalties, or loan acceleration.
Covenant Compliance Certificates are essential for businesses with loans to demonstrate their financial discipline and maintain trust with lenders. They function as an early warning system, highlighting possible financial difficulties before they escalate.
To stay compliant, businesses should understand all covenants, monitor financial ratios regularly, maintain accurate records, and communicate proactively with lenders if issues arise.
For more on loan covenants, see our Business Loan Covenants guide.
Further authoritative information on covenants is available via IRS and legal sources like Investopedia’s Loan Covenant article.