In a nutshell
Loan covenants are promises a borrower makes in a loan contract to do, or not do, certain things while the loan is outstanding. Financial covenants set minimum performance levels, such as debt service cover or maximum LVR. Reporting covenants require accounts or valuations at set times. Negative covenants restrict actions such as further borrowing or selling assets. Breaching a covenant can give the lender rights even if every repayment has been made.
Key points
- Covenants are ongoing promises, not just repayment obligations.
- Financial, reporting and negative covenants each work differently.
- A breach can be a default even when repayments are up to date.
- Covenants are more common in bank and larger facilities.
- Types
- Financial, reporting, negative
- Common in
- Bank and larger loans
- Breach
- Can trigger default
- Fix
- Waiver or variation
Most borrowers focus on the amount, the term and the repayments. Covenants are the other half of the bargain: promises about how the business will perform and behave while the loan is in place. They’re easy to skim past, and they can matter more than the repayment schedule. This entry explains the main kinds and how to handle them.
What kinds of covenants are there?
| Type | What it requires | Examples |
|---|---|---|
| Financial | Maintain measurable performance levels | Minimum debt service cover, maximum LVR, minimum net worth, maximum debt-to-earnings |
| Reporting | Provide information on time | Annual accounts within a set period, management accounts, valuations, BAS |
| Positive (undertakings) | Take certain actions | Keep insurance current, pay taxes when due, maintain licences |
| Negative | Avoid certain actions without consent | No further borrowing, no new security to others, no major asset sales, no change of control |
Loan agreements often group these under “undertakings” rather than using the word covenant, so look for both.
How are financial covenants tested?
Usually against your annual or half-yearly accounts. The contract defines each measure precisely (our serviceability entry explains how lenders read earnings) — what counts as earnings, which debts are included, which add-backs are allowed. Two businesses with the same results can pass or fail the same covenant depending on those definitions, so they’re worth reading closely.
Property-based covenants, such as a maximum LVR, may be tested through periodic valuations. A fall in property values can cause a breach even if the business is trading well.
What happens when a covenant is breached?
Loan contracts commonly list a covenant breach as an event of default. Depending on the wording, the lender may be able to:
- charge default interest or fees;
- require additional security or a reduced limit;
- review or cancel an undrawn facility;
- in serious cases, require early repayment.
In practice, many breaches are resolved by a waiver (the lender agrees not to act on a specific breach) or a variation (the covenant is reset). Lenders respond much better to a borrower who raises an expected breach before the test date, with an explanation and a plan, than to one who waits for the lender to find it.
How do you negotiate covenants you can live with?
Before signing:
- Model the covenants against your last few years of results and a realistic bad year.
- Check the definitions of earnings, debt and add-backs.
- Ask for headroom if the test levels leave little margin.
- Align testing dates with when your accounts are actually ready.
- Clarify consent processes for things you know you’ll need, such as equipment finance for new vehicles.
Small business loan contracts are covered by unfair contract terms laws, which ASIC administers, but the most useful protection is a set of covenants that genuinely fits your business. A specialist can help you compare lenders’ terms.
Are covenants always a bad thing?
Not necessarily. Covenants let lenders offer larger amounts or longer terms because they get early warning if something changes. For a business with steady results, sensible covenants cost little. The problems come from covenants set too tightly, defined unfavourably or forgotten until they’re breached.
Many smaller non-bank and unsecured loans use few financial covenants, relying on guarantees and shorter terms instead. That can suit businesses with uneven results. See bank vs non-bank lenders.
What reporting covenants should you diarise?
Reporting obligations are the covenants most often breached by accident. Common ones include:
- annual financial statements within a set number of days of year end;
- half-yearly or quarterly management accounts;
- copies of BAS as lodged;
- updated valuations of property security at set intervals;
- confirmation that insurance has been renewed.
Put every date in the calendar at settlement and tell your accountant which ones exist. A missed reporting deadline is an easy breach to avoid and an awkward one to explain.
Do covenants apply to guarantors too?
Often, indirectly. A guarantor’s insolvency or a judgment against them may be listed as an event of default for the main loan, and some guarantees include their own undertakings, such as providing personal financial statements each year. Guarantors should read the covenant and default sections as closely as the borrower does.
Terms used in this entry
- Covenant — a contractual promise to do or not do something. Glossary →
- Waiver — a lender’s agreement not to act on a particular breach. Glossary →
- Interest cover ratio — earnings before interest and tax divided by interest expense. Glossary →
- Net tangible assets — assets minus intangibles and liabilities. Glossary →
Worked example (illustrative)
Illustrative only. A food manufacturer’s bank facility requires it to maintain a minimum debt service coverage ratio, tested annually. A spike in ingredient costs means this year’s result will fall just short.
Two months before the accounts are due, the finance manager sends the bank a short note: the expected result, the cause, the price increases already passed on to customers and management accounts showing recovery. The bank grants a one-off waiver for the year. Had the breach first surfaced in the annual review, the conversation would have been harder.
Want a facility with terms that fit your business?
The right lender and the right covenants make growth easier, not harder. Enquiring takes about 60 seconds and there’s no credit check when you first enquire. We don’t circulate your details to multiple lenders — a real person reviews your business and calls you. Please describe your existing facilities and how steady your results are as accurately as you can so we can match you properly first time.
Frequently asked questions
What is a financial covenant?
A promise to maintain a financial measure, such as a minimum debt service coverage ratio, a maximum LVR, a minimum net worth or a limit on total debt relative to earnings. They're usually tested on annual or half-yearly accounts.
What is a negative covenant?
A promise not to do something without the lender's consent — typically borrowing elsewhere, granting security to another lender, selling major assets, paying large dividends or changing ownership.
What happens if I breach a covenant?
The contract may treat it as an event of default, giving the lender rights such as charging default interest, requiring repayment or reviewing the facility. In practice, lenders often agree a waiver or variation if the issue is explained early.
Do small business loans have covenants?
Many small, unsecured and non-bank loans have few or no financial covenants, relying on guarantees and security instead. Bank facilities and larger loans are more likely to include them.
Can I negotiate covenants?
Often, before signing. Lenders may adjust test levels, testing frequency or definitions if you can show why the standard terms don't suit your business.