What is Loan Covenant?

Full Definition

A loan covenant is a condition written into a business loan or facility agreement that the borrower agrees to comply with for as long as the loan is outstanding, on top of simply making the scheduled repayments. Covenants generally fall into two categories: financial covenants, which require the business to maintain certain financial ratios or thresholds -- such as a minimum interest coverage ratio, a maximum debt-to-equity ratio, or a minimum level of working capital -- tested periodically (often quarterly) against management accounts; and non-financial (or "negative") covenants, which restrict specific actions, such as taking on further borrowing, paying dividends above a certain level, selling key assets, or changing the nature of the business, without the lender's consent. Breaching a covenant is a default event under most facility agreements even if repayments are otherwise being made on time, and it typically gives the lender the right to demand immediate repayment, renegotiate terms (often with tighter conditions or higher margins), or in some cases enforce security over business assets -- though in practice many lenders will first waive a breach or agree a covenant reset if the business explains the cause and shows a credible plan to get back within limits. Because covenant breaches can be triggered by events outside day-to-day trading -- such as a one-off asset write-down or a change in accounting policy -- businesses with covenanted facilities usually monitor their covenant headroom closely as part of routine cash flow forecasting.

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