How can refinancing business debt improve covenant compliance?

Refinancing business debt is a tactical move that replaces one loan with another to change the economics and conditions of borrowing. For businesses at risk of violating debt covenants — rules embedded in loan agreements such as minimum debt-service coverage ratios (DSCR), maximum leverage ratios, or liquidity tests — refinancing can reduce monthly payments, adjust amortization schedules, and sometimes negotiate covenant relief. The result: improved compliance, more predictable cash flow, and breathing room to execute turnarounds or growth plans.

Below I explain when refinancing makes sense, the calculations lenders and finance teams run, negotiation strategies that work, and the costs that can offset the apparent benefits. I’ve advised more than 500 businesses on these decisions; the guidance here reflects common lender behaviors and the practical trade-offs I see in the field.

Sources and further reading: U.S. IRS guidance on cancellation of debt and potential tax consequences (IRS.gov), Consumer Financial Protection Bureau resources on small-business lending (consumerfinance.gov), and Small Business Administration financing guidance (sba.gov).

When refinancing helps (and when it doesn’t)

Refinancing is most useful when one or more of these are true:

  • Your current loan has high periodic payments that stress cash flow and threaten covenant ratios.
  • Market interest rates or your credit profile allow materially lower rates or better margins.
  • You can extend maturities so principal amortization no longer drags ratio calculations.
  • You can combine multiple facilities into a single structure that simplifies covenant testing.

Refinancing is less likely to help if significant fees outweigh savings, the new lender imposes tougher covenants, or a short-term operational problem (not financing cost) is the root cause of covenant stress.

Typical covenant problems refinancing targets

Common financial covenants include:

  • Debt Service Coverage Ratio (DSCR): EBITDA or NOI divided by debt service. Lenders commonly require DSCR ≥ 1.2–1.5.
  • Leverage Ratio (Debt / EBITDA or Debt / Equity): Maximum permitted leverage to limit default risk.
  • Current Ratio or Quick Ratio: Short-term liquidity tests for working capital.
  • Interest Coverage: Ability to pay interest from operating income.

If a refinancing lowers interest or stretches principal payments, it often raises DSCR and interest coverage and reduces near-term leverage — immediately improving covenant headroom.

Step-by-step refinancing analysis (practical math)

  1. Gather current loan details: outstanding principal, coupon/spread, amortization schedule, prepayment penalties, and explicit covenant texts.
  2. Build a 12–36 month “as-is” cash-flow and covenant test.
  3. Solicit indicative terms from 2–4 lenders: new rate, origination fees, prepay penalties, and maturity.
  4. Create a break-even analysis:

Example (simplified):

  • Current loan: $3,000,000 outstanding, 8% interest, 5-year amortizing, monthly payment ≈ $60,870.
  • New loan offer: $3,000,000, 5% interest, 7-year amortizing, monthly payment ≈ $45,887.
  • Monthly savings: $14,983 → annual savings ≈ $179,800.
  • Total upfront cost: 2% origination ($60,000) + 1% legal/fees ($30,000) + payoff penalty $20,000 = $110,000.
  • Payback period: $110,000 / $179,800 ≈ 0.6 years.

This shows refinancing is attractive if the savings increase covenant headroom and the payback is under the period you expect to maintain the loan.

Covenant negotiation during refinancing

Refinancing is an opportunity to seek covenant relief. Typical concession types include:

  • Interest-only periods for 6–18 months to boost DSCR.
  • Increased maturity or lower amortization to reduce principal service.
  • One-time covenant waivers or step-down covenant thresholds tied to performance triggers.
  • Repricing the covenant definitions (e.g., add-backs to EBITDA) to reflect one-off costs.

Lenders are more receptive when you provide a realistic recovery plan, updated forecasts, and—where possible—additional collateral or a guarantor. Transparency and early engagement improve odds of concession. In my practice, a pre-emptive data room (updated financials, budget, sensitivity scenarios) shortens negotiations.

Costs and pitfalls to watch

  • Upfront fees: origination points, legal, appraisal, environmental reports, and trustee fees. These can be 1–4% or higher depending on the facility.
  • Prepayment penalties: many commercial loans include yield maintenance or defeasance — especially mortgages — that can make refinancing expensive. See our article on refinancing commercial mortgages for strategies to avoid triggering large penalties: “Refinancing Commercial Mortgages Without Triggering Prepayment Penalties”.
  • New covenant tightening: a cheaper rate is not always a net win if the new lender asks for tougher covenants or more restrictive reporting.
  • Tax implications: cancellation of debt (if any principal is forgiven) may create taxable income; consult IRS guidance and a tax advisor before closing (IRS.gov).

Useful related reading on costs and alternatives includes our posts on when consolidation makes sense and small-business refinancing steps: “Refinancing Business Debt: When Consolidation Makes Sense” and “Refinancing Small Business Loans: Alternatives and Steps”.

Practical documentation lenders will request

Prepare these documents to speed approval:

  • Last 2–3 years of financial statements and tax returns.
  • Year-to-date profit & loss and balance sheet, aged A/R and A/P.
  • Cash-flow projections and covenant testing schedules for 12–36 months.
  • Business plan or turnaround plan explaining how refinancing improves performance.
  • Copies of existing loan agreements and security documents.

Faster responses come from having an organized data room and a concise covenant impact memo.

Negotiation tactics and lender perspectives

From the lender’s view, refinancing should reduce risk or be priced to reflect it. Tactics that work:

  • Offer additional security or a partial personal guarantee for better pricing.
  • Propose covenant step-ins: tighter ratios that loosen as performance improves (gives lender protection while providing short-term relief).
  • Ask for temporary forbearance or covenant holiday during an initial recovery period.

In my experience, lenders reward credible forecasts and independent verification (third-party appraisals or audited statements).

When to consider alternatives to refinancing

Refinancing is not the only tool:

  • Restructuring or loan modification may be cheaper if only covenant wording needs amendment.
  • Short-term bridge financing to cover a temporary liquidity hole.
  • Equity injection or mezzanine financing to reduce leverage.

Compare the total cost (fees + new interest + covenant impact) of each option before deciding. Our decision framework article “Refinancing vs Restructuring Business Debt: Decision Framework” can help weigh options.

Post-refinance governance and covenant monitoring

After closing, maintain a disciplined covenant monitoring process:

  • Monthly variance reporting tied to covenant tests.
  • Rolling 12-month forecasts that show how you remain in compliance.
  • Early-warning triggers and board-level reporting when headroom falls below agreed thresholds.

Proactive monitoring prevents surprises and preserves negotiating leverage if circumstances change.

Final checklist before signing

  • Run a break-even: months to recoup upfront costs.
  • Confirm all prepayment penalties and how they are calculated.
  • Validate covenant language — small definitional changes can materially change results.
  • Consult tax counsel about any forgiveness or reacquisition tax issues.
  • Ensure internal controls for covenant reporting are in place.

Professional disclaimer: This article is educational and reflects general best practices as of 2025. It is not individualized financial, tax, or legal advice. Consult your CPA, tax attorney, or lending counsel before making decisions that affect your business debt structure.

Internal resources referenced (FinHelp):

Authoritative resources:

If you want, I can create a customized refinance break-even template or a covenant testing spreadsheet tailored to your loan documents.