The four covenants in most small business loans
A loan covenant is a condition written into a loan agreement that the borrower agrees to meet for as long as the loan is outstanding. Some are things you must do, such as send statements and keep insurance. Some are things you must not do, such as take on new debt or sell assets. The ones that catch owners are the financial covenants, which are ratios tested against your own numbers.
Debt service coverage is the most common. It is cash generated divided by principal and interest due, and the bank wants it above a floor. Commerce Bank's 2026 guidance puts the typical conventional minimum at 1.2, and a summary of SBA post-closing practice by the advisory firm ClearlyAcquired notes that many SBA lenders write a 1.25 maintenance requirement into the loan. How the ratio is built is in DSCR for business owners.
A leverage covenant caps how much you owe relative to what you earn or own, usually written as total debt divided by EBITDA or total liabilities divided by tangible net worth, with the ceiling set in the agreement.
A liquidity covenant sets a floor on cash or working capital: a minimum current ratio, or a minimum unrestricted cash balance, tested at quarter end.
A distribution covenant limits what owners can take out, either as a dollar cap or as a rule that draws cannot push coverage below the floor. It is the one that quietly decides the others, because distributions are the line the owner controls.
What the compliance certificate contains
A covenant compliance certificate is a one- or two-page form, signed by an owner or officer, that lists each financial covenant, shows the calculation, states the required level, and declares whether the borrower is in compliance. The statements it is based on are attached.
The wording matters more than owners expect. The certificate usually says the signer has reviewed the loan agreement and that, to the best of their knowledge, no event of default exists. Signing one that turns out to be wrong is a separate problem from the breach. Read the definitions in the agreement before you sign, because the bank's definition of EBITDA is rarely the one on your QuickBooks P&L. It commonly subtracts distributions and unfinanced capital spending, and adds back only what the bank has agreed to.
The reporting calendar
Banks ask for financial statements because the covenant is tested on them, and because the bank's regulator expects it to know how its borrowers are doing. ClearlyAcquired's timeline for SBA loans is a fair guide for conventional ones too. Year one is usually monthly. After that, a quarterly P&L and balance sheet, typically due within 45 days of quarter end. Then an annual package within 90 to 120 days of fiscal year end: business tax returns, balance sheet, P&L, cash flow statement, personal returns for anyone owning 20 percent or more, and a personal financial statement, which for SBA loans is Form 413. At closing, SBA lenders also need the settlement sheet, Form 1050, within 45 days of disbursement.
For a new application or a renewal, most lender checklists ask for a year-to-date P&L and two or three prior years, a balance sheet, a cash flow statement, two or three years of tax returns, a debt schedule, AR and AP aging reports, and three to six months of bank statements. The aging reports are the ones owners forget; how to read an AR aging report covers what the bank sees in yours.
What a breach looks like in practice
A covenant breach is any test the borrower fails or any promise it does not keep, whether or not a payment was missed. Late quarterly statements are a breach as much as coverage of 1.14 against 1.25.
A technical default is the term for that: an event of default under the agreement with every payment made on time. Most agreements give the bank the right, not the obligation, to act.
What usually happens is a waiver. A covenant waiver is the bank's written agreement to overlook a specific breach for a specific period, often for a fee and sometimes with conditions: a higher rate until the ratio recovers, more frequent reporting, a block on distributions. A cure period is a window, commonly 30 days, in which the borrower can fix a breach before it counts. Whether a breach becomes something worse depends on the trend and on whether the bank heard it from you first.
We do not have good data on how often small business covenants are breached or waived; nobody publishes it. What we see is that a first breach the owner reports early, with a plan, is priced differently from one the analyst finds in April.
The multi-entity version
Owners with several companies sign several loan agreements. The agreements refer to each other. A cross-default clause says that a default under one loan is a default under this one. A cross-guarantee makes each entity liable for the others' loans. Together they mean a breach in the equipment LLC can put the operating company's line of credit in default while that company's numbers are fine.
The other question is which numbers the covenant is tested on: the borrowing entity alone, the borrower plus guarantors, or the owner's whole picture including the personal return. The agreement says which, and it is worth knowing before you move cash between companies. How a bank folds every entity and the household into one calculation is in global cash flow analysis for business owners.
A worked example
At the end of June, the trailing twelve months close for a trades owner with three entities: a service company, a construction company, and an LLC that holds the equipment. The equipment LLC has a $2.1 million term loan with a 1.25 coverage covenant, tested on the trailing twelve months of the three entities combined, with coverage defined as EBITDA less distributions less unfinanced capital expenditure, divided by principal and interest.
| Trailing twelve months to 30 June | Amount |
|---|---|
| Combined EBITDA | $612,400 |
| Less distributions to owner | −$94,000 |
| Less unfinanced capital expenditure | −$61,500 |
| Cash available for debt service | $456,900 |
| Principal and interest, all three entities | $401,300 |
| Coverage | 1.14 |
| Covenant | 1.25 |
Revenue was up nine percent. The owner would have called it the best one yet. But $94,000 went out as tax distributions and a $61,500 used truck was bought with cash rather than financed, and the covenant subtracts both. Had distributions been held to $40,000, even with the truck still paid in cash, cash available would have been $510,900 and coverage 1.27, over the line, with nothing about the business itself any different.
The bank waived the breach for a $2,500 fee and a half-point rate step-up until the next annual test, and asked for quarterly certificates instead of annual. Those terms are illustrative; yours are in the agreement.
Monitoring monthly instead of annually
The common advice is to review your covenants once a year, when the compliance certificate is due. We think that is the wrong way round, because the levers that fix a ratio (holding a distribution, financing rather than paying cash, collecting receivables) only work before the test date.
A monthly check needs two lines: trailing twelve-month cash available, using the bank's definition rather than yours, and trailing twelve-month debt service across every entity the covenant covers, from the loan schedules. Divide, compare with the floor, and note the gap in dollars, because that tells you what to hold back.
One more reconciliation is worth doing before you sign anything. The bank usually tests on the tax return, and the tax return is not the management P&L. Your QuickBooks file might show $612,400 of EBITDA while the return, after the CPA's adjustments, shows $571,900. Tested on the return, you were at 1.04, not 1.14. Ask your CPA for a one-page bridge between the two each year and keep it with the certificate.
Navigator handles two pieces of this. On the Pro plan, coverage is tracked against the loan terms you enter, per entity and combined, and a one-click lender filing pack assembles what a bank asks for (some packs are still marked coming soon). Covenant monitoring against your specific agreement, with a named CFO watching the trend and telling you what to hold back, is part of the Navigator + CFO plan. Plans and prices are on navigatorhq.ai. Neither replaces the bridge your CPA prepares to the filed return.
What none of this can do is read the agreement for you. Definitions of EBITDA, the test period, which entities are included and the cure period vary from bank to bank, and the only reliable source is the document you signed.
Questions owners ask
What is a covenant compliance certificate?
A covenant compliance certificate is a short signed statement, usually one or two pages, that lists each financial covenant in your loan agreement, shows the calculation from your financial statements, states the required level, and declares whether you are in compliance. It is typically due with quarterly or annual statements, and the signer confirms that no event of default exists.
Does a covenant breach mean default?
Technically yes, in that a breached covenant is an event of default under most agreements, even if every payment has been made. In practice the bank usually has the right, not the obligation, to act, and most first breaches end in a waiver, a fee, tighter reporting or a rate step-up rather than the loan being called.
What is a covenant waiver?
A covenant waiver is the bank's written agreement to overlook a specific breach for a specific period. It often comes with a fee, sometimes a higher rate until the ratio recovers, and may add conditions such as more frequent statements or a block on owner distributions. A waiver covers only the breach named in it, not future ones.
What financial statements do lenders require annually?
For most term loans and lines of credit, the annual package includes business tax returns, a balance sheet, P&L and cash flow statement, personal tax returns for owners of 20 percent or more, a personal financial statement (Form 413 for SBA), an updated debt schedule and the compliance certificate. It is usually due 90 to 120 days after fiscal year end.
How often do banks check covenants?
It depends on the agreement. Quarterly testing is common for larger loans and in the first year; annual testing off the tax return is common for smaller term loans. Reporting is often monthly in year one and quarterly after. The bank checks on its schedule, but the levers that fix a ratio only work before the test date, so checking monthly yourself is the safer habit.
Related
The ratio behind most covenants is explained in DSCR for business owners, with the formula and what banks require. If you own more than one company, global cash flow analysis shows how the bank combines them before it tests anything. And if the loan is an SBA loan, the underwriting changes arriving on 1 October are in SBA DSCR requirements under SOP 50 10 8.1.
If you would like your coverage number on one page before the next certificate is due, the free accounting health check is a place to start: navigatorhq.ai/health-check.
Published . Last updated . Reviewed by a CFO on the Navigator team.