Covenant
A covenant is an ancillary clause in a loan agreement that obliges the borrower to meet certain financial ratios or rules of conduct. Typical financial ratios are leverage, interest cover and the equity ratio. A breach usually gives the lender a right to terminate.
Types of covenants
Financial ratios. The best-known group. Common are leverage (net financial debt to adjusted EBITDA), interest cover (EBITDA to interest expense), sometimes the equity ratio and a cap on capital expenditure.
Negative covenants. No further borrowing without consent, no distributions above a set limit, no sale of material assets, no change in the ownership structure.
Positive covenants. Delivery of financial statements and reports by fixed deadlines, insurance cover, compliance with statutory requirements.
Why the definition matters more than the ratio
The decisive work is not calculating leverage but knowing how the agreement defines it. Which EBITDA is meant – reported, adjusted, or a definition specific to the contract? Which adjustments are permitted, and is there a cap on them? Do shareholder loans count as financial debt? Is an acquisition annualised for the preceding twelve months?
These questions decide between compliance and breach, and they are asked surprisingly often only once things get tight. The calculation logic should be written down once, ideally agreed with the lender, and carried forward monthly in that form.
What happens on a breach
A breach usually leads not to immediate termination but to negotiation. Typical outcomes are a temporary waiver, a permanent reset of the thresholds, additional security, a higher margin or an equity injection by the shareholders. All of these routes are open – the decisive factor is when the lender is told.
A breach announced three months in advance and backed by an action plan is a conversation. The same breach discovered by the lender in the submitted report is a loss of trust – and trust is the real currency in these negotiations.
What the finance function has to deliver
Three things: calculate the ratios monthly, not only at the contractual test date; forecast them in the integrated plan so that a looming breach becomes visible months ahead; and meet the reporting obligations on time. A missed reporting deadline is, incidentally, the most common covenant breach of all – and the only one that is entirely avoidable.