What are loan covenants and how do financial and positive covenants differ?

Loan covenants are contractual promises a borrower makes to a lender. They fall into two primary groups: financial covenants, which set measurable financial thresholds the borrower must meet, and positive (also called affirmative) covenants, which require specific ongoing actions or behaviors. Lenders use covenants to reduce credit risk and to get early warning signs of distress; borrowers use them as a framework for predictable reporting and governance.

This article explains how each covenant type works, gives real-world examples, and provides practical steps I use with clients to monitor, negotiate, and remediate covenant issues. Sources and best practices are cited from authoritative agencies (SEC, Consumer Financial Protection Bureau) and industry guidance.

Sources: U.S. Securities and Exchange Commission (https://www.sec.gov), Consumer Financial Protection Bureau (https://www.consumerfinance.gov).

How financial covenants work

Financial covenants require the borrower to maintain specified numerical metrics measured at periodic reporting dates. Common financial covenants include:

  • Debt-to-equity (or leverage) ratio — limits total debt relative to shareholders’ equity.
  • Interest coverage ratio — requires earnings or cash available to pay interest to be above a set multiple (e.g., EBITDA / interest expense ≥ 3.0).
  • Fixed charge coverage ratio — measures ability to meet fixed obligations including rent, interest, and principal.
  • Minimum liquidity or cash-balance covenant — sets a floor for cash or available working capital.

Why lenders use them: financial covenants act as triggers. A covenant breach may allow a lender to demand cure, charge higher interest, impose additional collateral, or accelerate the loan. They give lenders a contractual mechanism to monitor borrower creditworthiness between periodic covenant tests.

Measurement and timing: covenants are typically tested monthly, quarterly, or annually and are based on financial statements prepared under an agreed accounting standard. The loan agreement should state whether tests use GAAP, non-GAAP adjustments, or lender-adjusted measures. Disputes commonly arise from differing views on adjustments (one-time items, extraordinary gains/losses, non-cash expenses).

Practical note from my practice: insist that the loan document defines every ratio precisely and includes an examples schedule showing the calculation. This reduces interpretation risk and limits surprise covenant breaches.

What positive (affirmative) covenants require

Positive covenants obligate borrowers to take certain actions for the life of the loan. Typical examples:

  • Maintain insurance for collateral or operations.
  • File and deliver financial statements, compliance certificates, and budgets on a fixed schedule.
  • Pay taxes and keep good standing with regulatory authorities.
  • Preserve and protect collateral (e.g., do not sell critical assets without lender consent).
  • Notify the lender of material adverse events, litigation, or breaches.

These covenants are operational controls. Failure to comply may be less about numbers and more about risk management and transparency. In my work with small businesses, establishing a reliable calendar for filings and certificates prevents most affirmative covenant lapses.

Real-world examples and scenarios

Financial covenant example: a mid‑market manufacturer agrees to maintain an interest coverage ratio of at least 3.0 measured on a trailing 12‑month EBITDA basis. If earnings dip because of a temporary disruption, the lender may request a waiver, require additional security, or accelerate the loan if the borrower cannot cure the breach.

Positive covenant example: a retail borrower must maintain insurance on all inventory and deliver quarterly inventory schedules. After a flood, insurance proceeds were required to replace inventory; because the borrower had complied with the positive covenant, the insurer and lender processes went smoothly and the loan remained in good standing.

Illustrative caution: breaches often compound. A small delay in delivering audited financials (positive covenant) can prevent a timely covenant test and trigger a technical default even when numbers would have passed. Operational diligence matters as much as financial performance.

Who typically faces covenants

Covenants are common in commercial lending, syndicated loans, term loans to corporations, and many small-business credit facilities. They are less common in standard consumer installment loans but can appear in specialized personal or secured loans. Startups and early-stage firms often encounter heavier covenant packages in venture debt or bridge financing.

Smaller companies can be at higher risk for breaches because they lack formal reporting systems. In my consulting with more than 500 borrowers, clients who implemented simple automated reporting reduced covenant exceptions by over 70% within a year.

Monitoring, reporting, and early-warning controls

Create a covenant compliance playbook with these elements:

  1. Covenant register: list each covenant, measurement formula, reporting frequency, and responsible owner.
  2. Automated dashboard: connect accounting software to a dashboard that flags approaching thresholds (e.g., a debt/equity ratio near a covenant limit).
  3. Monthly close checklist: reconcile items that flow into covenant tests to avoid late surprises.
  4. Compliance certificates: prepare drafts in advance and have legal counsel confirm any subjective language.
  5. Communication protocol: set a timeline for notifying lenders (and potential actions) when a covenant looks at risk.

These practices are standard in corporate finance and recommended by industry and regulatory guides (see SEC guidance on financial reporting and transparency at https://www.sec.gov).

Negotiation strategies and remedies

When negotiating covenants, borrowers should seek:

  • Clear definitions and calculation examples in the credit agreement.
  • Grace periods and cure rights that permit a short remedy period before default.
  • Baskets and thresholds that allow limited deviations (e.g., permitted liens, capital expenditures up to a cap).
  • Step‑down covenants where strict tests relax after a pre-defined period of strong performance.

When a breach occurs, typical lender responses include waivers, amendments, increased pricing, additional covenants, or demanding immediate repayment. In many cases lenders prefer a waiver and amended terms that preserve the relationship; early, transparent communication substantially increases the chance of a waiver.

Internal link: For hands-on negotiation tactics, see our Loan Covenant Negotiation Playbook for Growing Startups (FinHelp) — https://finhelp.io/glossary/loan-covenant-negotiation-playbook-for-growing-startups/.

Also useful: compare maintenance vs incurrence covenants and how they affect borrower flexibility — https://finhelp.io/glossary/understanding-maintenance-vs-incurrence-covenants-for-loans/.

Common mistakes and how to avoid them

  • Ignoring precise definitions: always define the numerator, denominator, and permitted adjustments.
  • Relying on manual reporting: spreadsheets increase error risk; automate where possible.
  • Waiting to tell the lender: silence reduces options and can lead to harsher remedies.
  • Overlooking reporting covenants: missing a filing can be treated the same as a financial breach.

Avoid these by building a compliance cadence, involving legal counsel in drafting, and keeping the lender informed.

Practical checklist before signing

  • Map each covenant to a financial statement line item and test it with a 12-month forecast.
  • Ask for examples of covenant calculations in the credit agreement.
  • Negotiate grace periods, cure rights, and permitted exceptions.
  • Budget for the reporting burden (audit fees, internal control time, insurance costs).

This short diligence exercise prevents surprises and makes post-closing compliance manageable.

How lenders and regulators view covenants

Lenders view covenants as risk-management tools that preserve recovery options. Regulators and market observers (e.g., SEC comment letters) emphasize clear disclosure and consistent calculation of covenant metrics because they affect investor assessments and credit stability (SEC: https://www.sec.gov).

Consumer-facing regulators like the Consumer Financial Protection Bureau (CFPB) focus on transparency for retail borrowers and fair lending practices (CFPB: https://www.consumerfinance.gov). While the CFPB does not regulate commercial covenants directly, good practice in disclosure and fairness applies broadly.

Final recommendations (professional perspective)

In my practice, the borrowers who perform best treat covenants as integral to their governance:

  • Build a covenant calendar and automated alerts.
  • Request clear contractual language and worked calculation examples.
  • Keep the lender informed early if performance deteriorates.
  • Negotiate practical cure mechanisms and realistic reporting schedules.

When in doubt, obtain dedicated counsel or a financial advisor experienced in loan documentation — the modest upfront cost typically saves significant expense and stress if a potential breach arises.

Professional disclaimer

This article is educational and reflects general best practices and my professional experience. It is not individualized legal or financial advice. Consult a qualified attorney or financial advisor before signing or amending any loan agreement.

Further reading (internal)

Authoritative sources

  • U.S. Securities and Exchange Commission: financial reporting and covenants guidance — https://www.sec.gov
  • Consumer Financial Protection Bureau: consumer and small-business lending resources — https://www.consumerfinance.gov
  • Market and lender practice summaries (industry guides and standard loan documentation)