Most owners read a loan agreement for two numbers: how much and how much a month. The covenants are the pages after that, written in a register nobody enjoys, and they are the reason a business that has never missed a payment can find itself in default.
A covenant is a promise about how the business will be run and what condition it will stay in while the money is outstanding. Break one and you have an event of default, which gives the lender the right to demand repayment, enforce security, or — far more commonly — renegotiate from a much stronger position than the one they had when you signed.
The information covenants, which catch people first
These are the dull ones, and in small firms they cause more breaches than the financial ones do. Management accounts within a set number of days of each quarter end. Statutory accounts filed within a set number of months of your year end. Notification of a change of directors, of shareholding, of a material dispute or claim. Sometimes a requirement to maintain your banking with the lender, or to route a proportion of turnover through the account.
None of these look like a big deal at signing. Then a year passes, the bookkeeping falls behind, the management accounts go in six weeks late, and you are technically in breach of an agreement that governs a six-figure debt. In practice a lender rarely acts on a first information breach, but it changes the conversation — and if a financial covenant is also under pressure, an information breach gives them the excuse to act early.
The three financial covenants worth understanding
Debt service cover is the most common. It compares your earnings before interest, tax, depreciation and amortisation with the total loan repayments due in the year, and a typical requirement is 1.25 times. Suppose your EBITDA is £180,000 and your annual debt service is £120,000 — you are at 1.5 times, comfortable. Now lose £40,000 of profit, which in most small businesses is one client or one bad quarter. EBITDA of £140,000 against the same £120,000 is 1.17 times, and you are in breach, while every payment has gone out on the day it was due.
Leverage, or net debt to EBITDA, is the second. Say the cap is 3 times. With net debt of £450,000 and EBITDA of £180,000 you are at 2.5 times. The same £40,000 profit drop takes you to 3.2 times and breaches it. Note that the same single event has now broken two covenants, which is not a coincidence — most covenant sets are driven by the same profit line, so they tend to fail together.
Minimum net worth is the third and the sneakiest, because it can be breached without trading changing at all. It requires net assets, or tangible net assets, to stay above a stated figure. A large dividend, a director drawing down a loan account, or writing off an intangible can push you through it in a month when the business is trading perfectly well.
You can pay a loan perfectly and still default on it. That sentence surprises most owners the first time they hear it, which is exactly the problem.
The negative covenants — what you can't do without asking
These restrict actions rather than requiring outcomes. A negative pledge stops you granting security to anyone else. There will usually be limits on additional borrowing, on disposing of assets above a certain value, on paying dividends or director's loans beyond a stated amount, and on changing the nature of the business or its ownership.
Two of these routinely surprise people. The first is that taking a small piece of asset finance or an invoice facility elsewhere can breach the borrowing or security restrictions on an existing loan. The second is cross-default: a breach on one facility can automatically trip every other facility you hold with that lender, and sometimes with others. If you are considering refinancing business debt or adding a second facility, the existing covenants are the first thing to read, not the last.
What actually happens on a breach
Almost never an immediate demand for repayment. What usually happens is a waiver: the lender agrees to overlook the breach, in writing, for that testing period. That waiver typically comes with a fee, tighter or more frequent reporting, sometimes a higher margin, and occasionally a request for additional security or a personal guarantee.
So the practical risk is not that the bank appears at the door. It is that the price of your money goes up at precisely the moment your profits went down, and that you are negotiating from the weaker end of the table. If security is already in place, it is worth understanding what a debenture and floating charge actually give the lender before that conversation happens rather than during it.
Five things to establish before you sign
Ask for the definitions in writing. EBITDA is not a standard term — whether directors' remuneration, one-off costs or rent on a related-party property are added back can move the ratio by a wide margin, and the definition is negotiable in a way the ratio often is not.
Model the covenants against your worst quarter in the last three years, not against your forecast. Forecasts are written by optimists; covenants are tested against reality.
Ask what headroom the lender expects at drawdown. Something in the region of 20 to 25% is a reasonable ask, and if the covenant only works on the assumption that next year goes to plan, the facility is too tight.
Establish the testing frequency and basis — quarterly on a rolling twelve months is very different from quarterly on the quarter alone, particularly for a seasonal business where one weak quarter in isolation says nothing.
And ask what happens on a technical breach: is there a cure period, and does a late set of management accounts sit in the same category as a missed ratio? Getting that answered before signing costs nothing. Getting it answered afterwards costs a waiver fee.
If you are still at the application stage, what a lender asks for before approving a loan covers the paperwork side, and building a cash flow forecast a lender will believe is the same exercise that will later tell you whether your covenants have room in them.
Common questions
What is a debt service cover ratio and what level is typical?
It measures how comfortably your earnings cover your loan repayments, dividing EBITDA by total debt service — capital and interest — for the period. A requirement of around 1.25 times is common for small business lending, meaning earnings must be at least 25% higher than the repayments falling due. The definition matters as much as the number: whether directors' remuneration, exceptional costs or related-party rent are added back to EBITDA can shift the ratio significantly, and those definitions are usually more negotiable than the headline covenant level. Ask for worked examples of the calculation from the lender before you sign anything.
What actually happens if you breach a loan covenant?
In most small business cases, not repossession. The lender's usual response is a waiver — a written agreement to overlook the breach for that testing period — and waivers come with conditions. Expect a fee, more frequent reporting, sometimes a higher interest margin, and occasionally a request for extra security or a personal guarantee. The real cost is that your funding gets more expensive exactly when the business is under pressure, and you negotiate from a weak position. Lenders enforce properly when a breach signals genuine distress rather than a one-off dip, so the sooner you raise it yourself, the better the terms tend to be.
Do all small business loans have covenants?
No. Smaller unsecured loans, typically under about £50,000, often have no financial covenants at all — the lender relies on a personal guarantee and on your payment record instead. Covenants become standard as facilities get larger, longer or secured: commercial mortgages, asset-backed lending, growth loans and anything with a bank rather than a short-term online lender. If you have been offered a facility with no covenants, that is not automatically good news either; check what security and guarantees sit behind it, because the lender's protection has to live somewhere in the document.
Can you negotiate loan covenants before signing?
Yes, and more successfully than most borrowers assume. Lenders are often firmer on the headline ratio than on the mechanics around it, so the productive asks are usually about definitions, testing and cure. Push on how EBITDA is defined, on whether testing is done on a rolling twelve months rather than a single quarter, on the level of headroom built in at drawdown, and on whether a cure period exists for administrative breaches such as late management accounts. Raising these before the offer is accepted costs nothing; raising them after a breach costs a waiver fee and a worse negotiating position.
