What covenants come with a line of credit, and what trips them?

The covenants, and how each is tested

Alongside those financial tests sit affirmative covenants (keep insurance, pay taxes, maintain the collateral, keep books in good order) and negative covenants (no other debt, liens, acquisitions, asset sales, changes of control or distributions beyond set limits without consent). Negative covenants cause fewer defaults than the financial tests, but they catch owners who take on equipment financing, a cash advance or a seller note without asking.

Coverage: fixed charges and debt service

Coverage covenants ask whether the business generates enough cash to meet its obligations. The fixed charge coverage ratio is the usual test on an asset-based line and common on bank lines. The numerator is typically EBITDA less capital expenditure not financed with debt, cash taxes and often distributions to owners. The denominator is scheduled principal and interest, and sometimes rent or other fixed obligations. The debt service coverage ratio is similar but usually simpler, and is the measure banks and SBA lenders most often use to size a loan. Conventional banks commonly look for at least 1.25x; SBA requires at least 1.15x, and from 1 October 2026 a change of ownership must show 1.25x on historical results. The covenant floor written into the agreement is a separate, negotiated number, and it is the one you are tested against.

The definitions are where covenants are won or lost. Two businesses with identical results can pass or fail the same ratio depending on whether distributions for owners' income taxes are deducted, whether capex financed on the line counts as financed, and which add-backs are allowed in EBITDA. Read the definitions before the ratio, and model them with your own figures before signing.

The ratio on the term sheet matters less than the definitions behind it. Model the covenant with your own numbers, quarter by quarter, before you sign.

Leverage and liquidity

A leverage covenant caps funded debt as a multiple of EBITDA. Senior cash-flow lenders to lower-middle-market companies commonly lend 2x to 3.5x EBITDA, and the covenant ceiling is set above the closing level to give room. Two things squeeze that room. First, the revolver balance counts as debt, so drawing heavily at a quarter-end pushes leverage up just when it is tested. Second, EBITDA is trailing twelve months, so a single weak quarter stays in the ratio for a full year. The treatment of add-backs matters here too; see EBITDA add-backs.

Liquidity covenants require a minimum level of cash or, on an asset-based line, of excess availability: the unused room between the borrowing base and what is drawn. They are more forgiving of a bad quarter than a coverage test, because they look at cash rather than earnings. They are less forgiving of a working capital squeeze, such as a seasonal build or a large customer paying late, which can drain availability while the business is profitable.

Springing covenants on asset-based lines

Many asset-based lines do not test coverage every quarter. Instead, a fixed-charge covenant springs into effect when excess availability falls below a trigger, set in the agreement as a fixed amount, a share of the commitment or the base, or the greater of the two. Once triggered, the ratio is tested, often on the most recent trailing twelve months, and keeps being tested until availability has stayed above the trigger for a set period.

The trap is timing. Availability falls most when the business is under strain, which is exactly when trailing coverage is weakest. A springing covenant that never mattered in good years can trip the first time it applies. The trigger level is therefore one of the most important numbers to negotiate: set it against your seasonal low point in availability, not your average. Springing triggers often also switch on cash dominion and more frequent borrowing base reporting.

Reporting covenants: the easiest default to avoid

The covenant easiest to break is not a ratio. It is a deadline. Line of credit agreements typically require:

• Monthly or quarterly financial statements within a set number of days after period-end
• Annual statements, reviewed or audited by an outside accountant, within a set period after year-end
• A compliance certificate with each set of statements, showing each covenant calculation and signed by an officer
• Borrowing base certificates, agings and inventory reports on an asset-based line
• Annual budgets or projections
• Prompt notice of litigation, defaults under other agreements or material adverse events

Late delivery is a default in its own right, and it tells the lender something about the finance function. Most agreements give a short grace period for reporting defaults. Use it deliberately: tell the lender before the deadline, not after.

Negotiating covenants before you sign, and what to do if one trips

Covenants are negotiated at the term sheet, when you have the most leverage and the lender has the least information about your bad quarters. The points worth pressing:

• Cushion. Set each ratio against a downside case of your own model, not the base case. Ask how much EBITDA can fall before each test fails.
• Definitions. Settle add-backs, the treatment of owners' tax distributions and financed capex in writing.
• Test dates. A first test date after the seasonal trough, and trailing periods that do not start with a known weak quarter.
• Cure rights. The right to cure a coverage or leverage miss with an equity contribution, within limits.
• Springing triggers. A trigger set below your normal seasonal low in availability.

If a breach is coming, the order of operations matters. Model it early, go to the lender before the compliance certificate is due, bring a cause and a plan, and ask for a waiver or an amendment rather than waiting for the lender to discover it. Lenders expect to charge a fee and may tighten terms, but they usually prefer a documented fix to a default. If the relationship cannot carry it, the alternative is refinancing into a structure that fits. Both routes are covered in what to do when you breach a loan covenant.

Transparent's financing model tests each proposed covenant quarter by quarter against the borrower's own monthly figures before a term sheet is signed. With 235 lenders in the book that write asset-based loans and lines, and 1,148 that write term and private credit, there is room to choose a structure whose covenants fit how the business actually moves.