Covenants in Financing: What They Are

When a bank or a lender grants a significant loan to a business, it rarely limits itself to setting the amount, rate and maturity. The contract also includes covenants: undertakings and constraints that the borrower accepts for the entire duration of the financing. They are the instrument by which the creditor keeps risk under control without asking for security over every asset. Understanding how they work is decisive before signing, because a breached covenant can turn a long-term loan into a debt that is callable overnight.

What covenants are

A covenant is a contractual clause by which the company undertakes to do, not do or maintain something. They serve to protect the lender against the deterioration of the borrower’s economic and financial situation during the life of the loan. Three broad families are distinguished.

• Financial covenants: undertakings measured by balance-sheet ratios, verified periodically.
• Affirmative covenants (positive): obligations to do, for example delivering the accounts within certain deadlines or maintaining insurance.
• Negative covenants: prohibitions, for example not taking on new debt or not distributing dividends beyond a certain threshold.

The most common financial covenants

Financial ratios are the heart of the mechanism. The most recurrent in corporate financing are:

• Financial leverage (net debt / EBITDA): measures how many times debt exceeds operating profitability.
• Interest coverage (EBITDA / interest expense): indicates whether the company generates enough income to cover interest.
• Equity ratio: the proportion of equity to total assets, very keenly watched by Swiss banks as an indicator of solidity.
• Debt service coverage: the ability to cover debt service (interest plus repayments) with cash flows.

Each ratio is set with a threshold (for example leverage not exceeding 3.5x) and a testing frequency, typically half-yearly or annual on the approved accounts.

Why the creditor asks for them

Covenants are an early-warning system. If a ratio worsens, the lender notices before the situation becomes critical and can step in: renegotiate, ask for additional security or, in serious cases, call the loan. For the company they are not only a constraint: complying with them signals financial discipline and can justify better terms on the rate.

What happens in the event of a breach

The breach of a covenant is a contractual event of default. It does not automatically mean the bank will demand immediate repayment, but it opens that right. In practice there are three scenarios:

1. Waiver: the creditor formally waives the right to enforce the breach for that period, often subject to conditions.
2. Reset of thresholds: the parameters are renegotiated to align them with the company’s new reality, sometimes with an increase in the rate or fees.
3. Acceleration: in the most serious cases the financing becomes callable and the security must be enforced.

The critical point is temporal: a breach discovered late leaves little room for manoeuvre. This is why the management of covenants must be integrated into management control, not left to the auditor’s annual verification.

How to manage them well

A few precautions reduce the risk of finding yourself out of parameter without warning:

• Calculate the ratios in advance, with quarterly projections, not only at year-end.
• Check the contractual definitions: EBITDA, net debt and equity may be defined in the contract differently from the statutory accounts.
• Negotiate adequate headroom: thresholds that are too tight make the covenant fragile to any seasonal fluctuation.
• Provide for cure clauses, which allow a breach to be remedied with a capital injection within a set period.
• Coordinate the covenants with the dividend policy and with any new financing, so as not to breach the negative covenants.

In summary

Covenants are not a banking formality: they are the mechanism by which debt remains sustainable and under control. Those who negotiate them carefully, understand the technical definitions and monitor them alongside the budget reach the tests without surprises. Those who sign them without reading them risk discovering too late that their loan has become callable.

Do you want to negotiate and monitor the covenants of your financing with the right structure? SIH ONE’s capital division supports the company from the negotiation with lenders to the ongoing control of the parameters.