Quick overview

Loan covenants are contract terms a lender includes to protect its investment. They can be affirmative (requirements to do something), negative (limits on actions), or financial (minimum ratios or limits). For small businesses, covenants are common in bank loans, lines of credit, and some alternative financing. Knowing typical examples helps you run the business to stay in compliance and preserve borrowing flexibility.

Common covenant types and practical examples

  • Financial covenants (most common)
  • Minimum current ratio (example: maintain current assets ÷ current liabilities ≥ 1.2). This protects short-term liquidity.
  • Minimum debt-service coverage ratio (DSCR) (example: DSCR ≥ 1.25) measures cash available to cover scheduled debt payments.
  • Leverage ratio or maximum total debt-to-EBITDA (example: Debt/EBITDA ≤ 3.0).
  • Minimum EBITDA or minimum net worth thresholds.
  • Affirmative covenants
  • Timely delivery of monthly or quarterly financial statements and bank reconciliations.
  • Maintenance of insurance, required licenses, and tax filings.
  • Negative covenants
  • Restrictions on taking additional debt, granting liens, or making large asset sales/dividends.
  • Limits on capital expenditures above a set dollar amount without lender approval.
  • Reporting and cash controls
  • Requirements to maintain a debt-service reserve account (DSRA) or provide cash sweeps.

These are typical examples lenders use, but exact tests and thresholds vary by lender, industry, and deal size.

Real-world example scenarios (practical context)

  • Seasonal retailer: required to keep a current ratio ≥ 1.2. When sales slow, the owner shortened supplier payment terms and trimmed slow-moving inventory to avoid breach. (In my practice I’ve seen this tactic work quickly.)
  • Service firm with growth plans: an agreement prohibited new secured debt. The business negotiated a carve-out during closing to allow small equipment leases without violating the covenant.
  • Small manufacturer: faced a DSCR covenant; when a large order was delayed, the owner notified the bank and requested a one-time covenant waiver rather than risk default. See guidance on enforcement and remedies in How Loan Covenants Are Enforced and What to Do If You Breach One.

Practical steps to manage covenants

  1. Map covenants to your accounting calendar — know when tests are measured and which statements affect them.
  2. Build a simple covenant dashboard (monthly) tracking each ratio and any reporting deadlines.
  3. Run “what-if” scenarios: model a 10–25% revenue dip and its effect on each covenant.
  4. Keep communication lines open with your lender; early notice can buy a waiver or amendment.
  5. Negotiate flexibility upfront — ask for seasonal adjustments, grace periods, or higher thresholds where reasonable. See negotiating tactics at Negotiating Loan Covenants: What Small Businesses Can Ask For.

Red flags and common mistakes

  • Treating covenants as suggestions instead of enforceable contract terms.
  • Only checking covenants quarterly (run monthly checks instead).
  • Ignoring reporting covenants — missed reports can trigger technical defaults even if ratios are met.
  • Accepting overly rigid covenants that block routine growth (e.g., bans on small debt or acquisitions).

What to do if you expect a breach

  • Notify the lender immediately and provide a short plan to cure the issue.
  • Ask for a waiver or short-term amendment; lenders often prefer a negotiated fix to declaring default.
  • Consider short-term liquidity fixes (temporary overdraft, delay dividends, postpone discretionary capex).

FAQs (short)

  • What happens if I breach a covenant? Possible outcomes include fees, higher interest, additional reporting, a required cure plan, or loan acceleration. Lenders may also grant waivers if engaged early.
  • Can I renegotiate covenants later? Yes — lenders sometimes amend covenants during restructures, refinancings, or when borrowers demonstrate improved performance. See Key Loan Covenants Explained for Small Business Borrowers for background on common tests.

Professional tips from practice

  • Automate ratio calculations in your accounting system so you catch trends early.
  • Keep at least one quarter of covenant risk as contingency in your cash plan.
  • Negotiate for audits or certificates from your CPA only when necessary — excessive third-party requirements add cost.

Sources and further reading

Professional disclaimer

This article is educational and does not constitute legal or financial advice. For decisions affecting your business financing, consult your lender, CPA, or an attorney.