What is a loan covenant?
A covenant is a promise in the loan agreement. It is separate from the promise to repay. Lenders use covenants to keep watch on the business during the life of the loan and to act early if risk increases.
Types of covenants
Financial covenants
These set numeric limits. Common examples in New Zealand business lending include:
| Covenant | What it measures | Why lenders use it |
|---|---|---|
| Interest cover | Earnings ÷ interest cost | Can the business comfortably service debt? |
| Debt service cover | Cash available ÷ total repayments | Can it meet principal and interest? |
| Gearing or leverage | Debt ÷ equity, or debt ÷ earnings | Is the business over-borrowed? |
| Loan to value | Loan ÷ security value | Is the security still adequate? |
| Minimum working capital | Current assets − current liabilities | Is there a short-term buffer? |
Each covenant sets a threshold. For example, a debt service cover covenant might require cash available for repayments to be at least a certain multiple of the repayments due.
General (non-financial) covenants
These are actions the borrower must or must not take:
- keep assets and security property insured
- pay taxes and rates on time
- not sell major assets without consent
- not take on further borrowing or give security to another lender without consent
- not change ownership or control without consent
- notify the lender of material events, such as litigation or loss of a major customer
Reporting covenants
These require information by set dates, such as:
- annual financial statements within a set period after year end
- quarterly or monthly management accounts
- compliance certificates confirming covenant calculations
- updated valuations of security property
Our guide on management accounts lenders like explains how to prepare reports that meet these requirements without stress.
How do breaches happen?
Most breaches are not dramatic. They happen because:
- A bad quarter pushes a ratio below its threshold.
- Reports are late because the accountant is busy or the books are behind.
- The owner takes on other finance, such as an equipment loan or an unsecured facility, without realising it needs consent.
- Tax falls behind, breaching a general covenant to pay taxes when due.
- Property values fall, pushing a loan-to-value ratio over its limit.
What happens after a breach?
A breach may give the lender the right to:
- charge default interest or fees
- require additional security
- demand repayment in full
- appoint a receiver in serious cases
In practice, lenders usually prefer to work with a borrower who communicates. A common outcome is a waiver for a one-off breach, or an amendment that resets the covenant level, sometimes with conditions.
How to stay on the right side of covenants
- Read the agreement. List every covenant, its threshold and its reporting deadline.
- Diarise deadlines. Put reporting dates in the calendar with reminders.
- Calculate monthly. Work out financial covenant ratios from management accounts each month, not just at test dates.
- Build headroom. If a ratio is close to its limit, act early: collect debtors, defer discretionary spending or refinance.
- Ask before acting. Before taking on new debt, selling assets or changing ownership, check whether lender consent is needed.
- Talk early. If a breach looks likely, contact the lender before it happens, with an explanation and a plan.
Covenants in different types of lending
| Facility type | Covenant intensity |
|---|---|
| Large bank term loans and overdrafts | Often several financial and reporting covenants |
| Property-secured SME loans | Mainly general covenants about the property and security |
| Unsecured SME loans and lines of credit | Usually general covenants; reporting may be limited to bank statement access |
When comparing options, consider covenants alongside cost. A slightly cheaper facility with tight covenants can be riskier for a business with lumpy earnings than a facility with fewer conditions.
When covenants signal it is time to refinance
If a business keeps bumping against covenants, or a lender has reset them repeatedly, the facility may no longer suit the business. Our guide on when to refinance business debt covers the signs. Refinancing into a better-fitting facility can restore breathing room.
Quick answers
Do all business loans have covenants?
Most have at least general covenants, such as keeping the business insured and paying taxes. Financial covenants are more common in larger bank facilities than in smaller short to medium term loans.
What happens if I breach a covenant?
The lender may have the right to treat it as a default. In practice, lenders often agree a waiver or amendment if the borrower communicates early and has a plan.
Can covenants be negotiated?
Sometimes, particularly the level of financial ratios and reporting deadlines. It is worth asking before signing, not after.
Are property-secured loans covenant-heavy?
Generally less so than large bank facilities, because the property security carries much of the lender's risk. Standard obligations still apply, such as keeping the property insured and rates paid.