Financial Covenants: What They Are, What Banks Require, and What Happens on Breach

A financial covenant is a commitment the borrower makes in the credit agreement and that is checked periodically against its financial statements: keeping a maximum leverage level, a minimum coverage, or a debt floor. Breaching it can make the full debt callable.

What Is a Financial Covenant?

A covenant is an obligation the borrower accepts in the credit agreement and that gets checked periodically — usually every quarter or every year — against its financial statements. Its purpose isn't to punish: it's to give the lender an early warning. If the borrower's situation deteriorates, the covenant breaks before the default hits, which opens the conversation while there's still room to act.

What Types of Covenant Exist?

Covenants fall into three families. Financial or maintenance covenants require holding an indicator within a range and are the only ones measured with a formula. Affirmative covenants require doing something, like delivering audited financial statements within a deadline. Negative covenants prohibit actions that would harm the lender, like taking on additional debt or paying out dividends above a certain percentage.

Financial or maintenance covenants

Require holding an indicator within a range: a maximum leverage level, a minimum coverage, an equity floor. These are the ones measured with a formula on the balance sheet and income statement, and the ones a system can monitor automatically.

Affirmative covenants

Require doing something: delivering audited financial statements within a deadline, keeping insurance in force, staying current on taxes, reporting material ownership changes.

Negative or restrictive covenants

Prohibit actions that would harm the lender: taking on additional debt above a certain amount, paying out dividends above a percentage, selling essential assets, granting liens to third parties over assets already pledged.

What Thresholds Do Banks Require?

Values depend on the industry, the term and the borrower's profile, but there's a fairly stable reference range in commercial banking. These are the thresholds CreditIQ ships configured by default — the criteria a bank uses to weigh them is governed by the credit risk standards of the Basel Committee on Banking Supervision and, in Chile, by CMF regulation:

An agreement rarely requires all seven. Two or three is typical, chosen based on which risk is the concern: if it's over-leverage, Debt/EBITDA and leverage; if it's liquidity, current ratio and DSCR.

How Are They Measured, and How Often?

Measurement happens on the calculation dates set in the agreement, against the financial statements for the corresponding period. The borrower usually has to deliver a signed compliance certificate detailing the calculation of each indicator.

• Quarterly is most common in corporate credit.
• Annual, on audited statements, in smaller or lower-risk deals.
• Monthly under intensive monitoring or restructuring.

What Happens If a Covenant Is Breached?

Formally, a breach constitutes grounds for acceleration: the lender becomes entitled to demand full and immediate repayment of the debt. In practice, that right is almost never exercised immediately, because acceleration usually destroys more value than it protects. What normally happens is one of three things:

• Waiver. The lender waives, in writing, its right to enforce that specific breach — often in exchange for a fee or a change in terms.
• Renegotiation. Thresholds are adjusted to fit the new reality, usually with something given in return: more collateral, a higher rate, dividend restrictions.
• Acceleration. Reserved for cases of severe deterioration or loss of confidence in management.

For the borrower, the worst way to face a breach is having the bank spot it first. A covenant breach seen two quarters ahead gets negotiated; one that shows up as a surprise on the compliance certificate gets endured.

How CreditIQ Monitors Them

CreditIQ calculates every covenant on the loaded financial statements and flags, period by period, whether the indicator is in compliance or in breach, counting cumulative breaches. Thresholds come with market reference values and adjust to whatever each agreement specifies.

Since the calculation runs on the same base as the risk analysis, the stress-test module shows how much of a sales drop or a rate increase would break each covenant. That's the information that turns monitoring into anticipation.