Financial Covenant

Financial covenants protect lenders by giving them early warning if a borrower's financial health deteriorates, and the right to act before the situation becomes worse.

Common financial covenants include a maximum ratio of debt to EBITDA, a minimum interest coverage ratio, a minimum fixed-charge coverage ratio, a minimum level of net worth or liquidity, and limits on capital spending.

For example, a loan might require a company's net debt to stay below three times its EBITDA, tested every quarter. If EBITDA falls and the ratio rises to 3.5, the company breaches the covenant.

A breach usually gives the lender the right to demand immediate repayment, increase the interest rate or impose new conditions. In practice, lenders often agree waivers or amendments, typically in exchange for a fee or tighter terms. Maintenance covenants are tested regularly, while incurrence covenants are tested only when the borrower takes a specific action, such as borrowing more. Loans with few or no maintenance covenants are called covenant-lite.