Loan Covenants Explained: What They Are, Why Banks Require Them, and What Happens When You Breach One

Your loan agreement is not the document that gets summarized at closing and filed away. It is a contract you live with for the life of the loan — and buried in the middle of most commercial loan agreements is a section that most borrowers don't read carefully enough: the covenant section.

Covenants are contractual performance requirements. They're the bank's monitoring mechanism — the conditions you agreed to maintain when they gave you the money. Violating them can trigger consequences that are independent of whether you're making your payments. And most borrowers don't discover this until they're in violation.

The Three Types of Covenants

Financial Covenants

These require you to maintain specific financial ratios or metrics at defined levels, tested at defined intervals. The most common:

• DSCR covenant — the most universal. Requires your business to maintain a minimum debt service coverage ratio, typically 1.20x or 1.25x, tested annually using your tax returns or CPA-prepared financial statements. The DSCR is calculated using the formula specified in your loan agreement — read it carefully, because different banks calculate it slightly differently.
• Minimum liquidity — requires you to maintain a minimum cash or current ratio. Less common in small business lending but appears in larger or more leveraged transactions.
• Maximum leverage — requires total debt to not exceed a multiple of equity or EBITDA. Common in leveraged acquisitions.
• Capital expenditure limit — restricts annual capex spending to a defined amount without lender approval. Protects against significant asset acquisitions that could affect cash flow.

Reporting Covenants

These require you to deliver specific financial information to the bank at specified intervals. Typical requirements:

• Annual tax returns — business and personal for all guarantors — due within 30 days of filing, typically by April 30 with extensions due within 30 days of filing but no later than October 30
• Annual CPA-prepared or company-prepared financial statements — P&L and balance sheet
• Interim financial statements — quarterly P&L and balance sheet for more active monitoring situations
• Annual personal financial statement — required for all owners of 20% or more
• Borrowing base certificates — monthly or quarterly for lines of credit
• Industry-specific reports — STR reports for hospitality, rent rolls for investment real estate, aging reports for lines of credit

Restrictive Covenants

These prohibit or limit specific actions without lender consent. Common examples:

• No additional indebtedness — you cannot take on new debt above a defined threshold without lender approval. This prevents you from encumbering the business with obligations the lender didn't underwrite.
• No change in ownership — significant ownership transfers require lender approval. Protects the lender's character assessment of the borrower.
• No sale of collateral — you cannot sell the assets securing the loan without paying off the loan or obtaining lender approval.
• No distributions above a defined level — common in deals where distributions were a concern in underwriting. Limits owner draws to protect cash flow available for debt service.
• Deposit account control — requires you to maintain your operating accounts at the lending institution. The bank wants to see your cash flow and have a deposit relationship.

What Happens When You Breach a Covenant

A covenant breach is a default event — technically. But in practice, most covenant breaches do not result in immediate acceleration or enforcement action. The bank has options, and most lenders prefer to work with a borrower in breach rather than take the escalation path.

The typical response progression:

• Notice of breach. The bank sends a formal written notice that a covenant has been violated. This is required before any remedial action.
• Cure period. Many loan agreements include a cure period — typically 30 days — during which the borrower can remedy the breach before the lender takes action.
• Waiver request. If the breach can't be cured in the short term, the borrower requests a formal waiver. This is a written agreement that the bank will not exercise its default remedies for a specified period, typically accompanied by conditions the borrower must meet.
• Loan amendment or restructuring. If the breach reflects a fundamental change in the borrower's financial condition, the bank and borrower may negotiate a formal loan modification — changing covenants, adjusting payment structure, or adding collateral.
• Acceleration. In serious situations, the bank may declare the loan in default and demand full repayment. This is the outcome everyone wants to avoid and that rarely happens for a first-time covenant breach with a transparent borrower.

Read Every Covenant Before You Sign

The best time to address a covenant that doesn't work for your business is before you sign the loan agreement. Once you've signed, you're bound by the terms. During negotiation, covenants are negotiable — the levels, the testing frequency, the cure periods, and the definitions. After signing, they're not.

• Know your actual DSCR for the past three years before you agree to a DSCR covenant level
• Make sure the DSCR calculation in the covenant uses the same methodology your banker used in underwriting
• Understand the testing frequency and timing — annual is less burdensome than quarterly
• Ask about cure periods for any financial covenant breach
• Understand the distribution restriction, if any, and how it interacts with your personal cash flow needs
• Know exactly what financial statements are required, when they're due, and what format (CPA-prepared, compiled, tax returns)