If you have a term loan or a line of credit, your bank expects a signed report on your financial covenants. Here is what it contains and how to stay ahead of it.
If your company has a term loan or a line of credit, your loan agreement almost certainly includes financial covenants: minimum standards your financial statements must meet for as long as the loan is outstanding. The covenant compliance certificate is the document that reports whether you met them.
It usually travels with your financial statements on the schedule the loan agreement sets, whether monthly, quarterly, or annually, and an officer of the company signs it. That signature is a representation to the bank, which is why the numbers on it deserve the same care as the statements themselves.
Most banks attach their own form to the loan agreement. The details vary, but nearly every certificate includes:
| Covenant | Common calculation | What it tells the bank |
|---|---|---|
| Current ratio | Current assets ÷ current liabilities | Whether short-term assets cover short-term bills |
| Debt service coverage | Cash flow available for debt service ÷ principal and interest due | Whether operations generate enough cash to make the loan payments |
| Tangible net worth | Equity minus intangible assets, and often minus loans to owners or affiliates | How much real cushion stands behind the loan |
| Leverage | Total liabilities ÷ tangible net worth, or funded debt ÷ EBITDA | How much of the business is financed by others |
| Fixed charge coverage | EBITDA less unfinanced capital spending, taxes, and distributions, ÷ principal, interest, and lease payments | Whether cash covers every fixed obligation after the owners are paid |
These are common forms. Your loan agreement’s definitions control, and they often differ.
Two companies with identical results can report different covenant numbers because their loan agreements define the terms differently. The details that change the answer most often are what counts as EBITDA, which add-backs are allowed, whether owner distributions are subtracted, and whether the test covers one quarter or the trailing twelve months.
A simple example: cash flow of $1,320,000 against annual debt service of $1,100,000 is a coverage ratio of 1.20x, which meets a 1.20x requirement exactly. If the agreement also subtracts $150,000 of owner distributions, the same year produces 1.06x, and the covenant is missed. Nothing about the business changed. Only the definition did.
A covenant miss is usually an event of default under the loan agreement, even when every payment has been made on time. Lenders most often respond with a waiver, sometimes for a fee, or an amendment that resets the covenant, tightens other terms, or raises the rate. In serious cases the agreement lets the bank demand repayment.
Banks respond far better to an early conversation than to a surprise. A company that tells its banker in advance that a covenant will be tight next quarter, and explains why, is in a much stronger position than one whose certificate arrives showing a miss.
Our lender package calculates each covenant from tied-out financial statements and assembles the certificate, the borrowing base, and a transmittal letter. A covenant with no requirement entered is shown as not tested, never as passing. To check your own coverage now, try the debt service coverage calculator.
This article is general information, not legal advice. Your loan agreement and your attorney have the final word.
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