Financial Covenant

A financial covenant is a promise in a loan agreement that the borrower will keep a stated financial measure above or below an agreed level for the life of the loan. Typical examples are a maximum ratio of debt to EBITDA, a minimum interest coverage ratio or a minimum net worth. If the borrower fails the test, the lender gains the right to declare an event of default.

Financial covenants are one part of a wider set of undertakings in a credit agreement, alongside information covenants (deliver accounts on time) and general covenants such as a negative pledge clause. They are the lender's early-warning system: a breach rarely leads straight to enforcement, but it brings the borrower back to negotiate, often ending in a loan covenant waiver or an amendment with new terms.

A financial covenant works like the warning lights on a car dashboard. The car can still be driven when a light comes on, but the driver has agreed to pull over and talk to the mechanic before the engine actually fails. The lender sets where the lights sit: how much debt is too much compared with what the business earns, or how thin the cushion over interest payments can get.

Each quarter or year, the borrower reads the gauges from its accounts and reports them. If a gauge crosses the line, the lender does not have to call in the loan, but it can. In practice this gives the lender a seat at the table early, while the business is still healthy enough to fix the problem.

• Leverage covenants. A cap on total or net debt as a multiple of EBITDA, the most common test in corporate and leveraged lending.
• Coverage covenants. A floor on interest cover, fixed-charge cover or the debt service coverage ratio (DSCR), which compare cash earnings with what the borrower must pay.
• Collateral covenants. A maximum loan-to-value ratio, common in real estate and asset-backed lending, which tracks the loan against the value of the collateral.
• Balance sheet covenants. A minimum tangible net worth, a maximum gearing ratio or a minimum level of working capital or liquidity.
• Capital expenditure limits. A cap on how much the borrower may spend on fixed assets each year, so cash is kept for debt service.

A net leverage covenant is usually written as:

• $\text{Total debt}$ is borrowed money as defined in the agreement, usually including leases and guarantees.
• $\text{Cash}$ is unrestricted cash the agreement allows to be netted off.
• $\text{EBITDA}_{\text{LTM}}$ is earnings before interest, tax, depreciation and amortisation over the last twelve months, with the adjustments the definition permits.

Suppose a company has total debt of 52 million, cash of 4 million and twelve-month EBITDA of 12 million, under a covenant of 4.25 times. Net leverage is (52 − 4) ÷ 12 = 4.0 times, so the test is passed with headroom of 0.25 turns. If EBITDA fell to 11 million, leverage would be 48 ÷ 11 ≈ 4.36 times and the covenant would be breached.

The lender and borrower agree the levels when the loan is signed, usually from the borrower's business plan with "headroom" (a cushion between the forecast and the covenant level) built in. How much headroom is given varies by market, lender and borrower strength. Levels may step down over time as the borrower is expected to repay debt. The borrower reports the result in a compliance certificate signed by a director and delivered with its financial reporting.

Much of the negotiation is about definitions rather than numbers. Add-backs for cost savings, one-off charges and acquisitions can raise EBITDA and loosen a test without changing its headline level. Some agreements also give an equity cure, letting the owners inject cash to repair a breach. The distinction between maintenance tests, checked every period, and incurrence tests, checked only when the borrower takes an action, separates a traditional loan from a covenant-lite loan.

A breach is normally an event of default, which can allow lenders to stop further drawings and accelerate the loan. It may also set off a cross-default clause in the borrower's other debt. Lenders rarely accelerate a performing borrower, because doing so can destroy the value they are trying to protect. The usual outcome is a waiver or reset of the levels, paid for with a fee, a higher margin, tighter terms or new security. Persistent breaches can lead to a full debt restructuring.

For banks, covenant compliance feeds into internal credit risk grading and into the assessment of whether credit risk has increased significantly under IFRS 9 expected-loss rules. For the borrower, a breach at the reporting date can force the debt to be shown as a current liability on the balance sheet, which is why treasurers watch headroom closely.

• Loan Market Association (LMA)
• IFRS Foundation