Loan Covenants Explained: What Lenders Require and How to Stay Inside Them

You got the loan. Funds are in the account. Most owners stop reading the paperwork at that point. That is a mistake. Buried in your loan agreement is a set of covenants, conditions that you are contractually required to maintain for the life of the loan. If you trip one, even once, the bank can demand immediate repayment of the entire balance.

What Loan Covenants Are

Covenants are promises you make to the lender as a condition of receiving funds. They exist in two forms.

Affirmative covenants require you to do something. File your financial statements annually. Maintain adequate insurance. Notify the lender of a major ownership change. These are administrative obligations.

Financial covenants require your business to hit or maintain specific financial ratios. These are the ones that catch owners off guard because they are tied to how well your business is performing, not just whether you remembered to file paperwork.

The Financial Ratios Lenders Watch Most

Different lenders use different metrics. These three appear most often in Canadian term loan agreements.

• Debt Service Coverage Ratio (DSCR). This compares your operating income to your total debt payments. A lender might require a minimum DSCR of 1.25, meaning for every dollar of debt payment, you generate $1.25 in operating income. A bad quarter can push this below the threshold.
• Debt-to-Equity Ratio. This measures how much of your business is financed by debt versus owner equity. If your liabilities grow faster than your equity, you can breach this covenant even without borrowing more money.
• Current Ratio. This is current assets divided by current liabilities. A required minimum of 1.0 means your short-term assets must cover your short-term obligations. A slow receivables month can temporarily move this ratio below the floor.

What Owners Get Wrong

Most small business owners do not know what covenants are in their loan agreement until they receive a breach notice. This is not an exaggeration. The loan was signed during a period of optimism, the document was thick, and no one walked through the financial triggers in plain language.

The second mistake is treating covenants as pass/fail at year-end. Many agreements require the bank to be notified promptly if you anticipate a breach. Waiting until you have already missed the threshold removes your options. Banks are far more flexible when you come to them early with a plan than when they discover a breach on their own.

The CFO Perspective

A generic example: a business with a term loan requiring a minimum DSCR of 1.20 had a strong year until one large client paused orders in Q4. Operating income dropped sharply for two quarters. The owner did not run the ratio because quarterly financials were never a priority. When the bank requested the annual statements, the DSCR came in at 0.95. The lender issued a demand for remediation. What could have been a proactive conversation in October became a crisis in February.

Running covenant ratios quarterly, not annually, is the single most practical thing a business owner with a term loan can do. It takes 20 minutes if your books are current.

What to Do About It

1. Read your loan agreement and extract the covenants. Pull the section titled covenants or conditions of lending. List every financial ratio, its minimum threshold, and the measurement frequency. If you cannot find it, ask your lender to walk you through it.
2. Build the ratios into your quarterly close. After each quarter-end, calculate your DSCR, debt-to-equity, and current ratio before you do anything else with the financials. Compare to your covenant floors.
3. Set a buffer. Do not wait until you hit the covenant floor to act. If your DSCR minimum is 1.20, treat 1.35 as your internal warning threshold. That buffer gives you a quarter or two to course-correct.
4. Contact your lender early if you see trouble coming. Banks have waiver processes. They grant waivers regularly to borrowers who communicate proactively, show they understand the issue, and present a credible plan. They almost never grant waivers after the fact to borrowers who said nothing.
5. Understand the cross-default clause. Many loan agreements include a provision that a breach on one loan triggers a default on all your loans with that institution. Know whether this applies to you.

Loan covenants are not fine print you can ignore. They are the ongoing terms of your financing relationship. The owners who manage them well treat their bank like a business partner who gets quarterly updates. If you are not sure what your covenants say or whether you are currently inside them, book a free call at peterxiacpa.com/book.