When your small business enters into a finance agreement with a lender there are often debt covenants that are attached to the agreement. Debt covenants are often designed with the goal of modifying company behavior in a direction that increases the chance that they debt will ultimately be paid off by sound business practices. Triggering a debt covenants can either lead to an required partial or full repayment of the outstanding loan or trigger other punitive measures. Debt covenants are either considered to be positive or negative covenants. Negative covenants are ones that limit your company’s ability to take certain actions, such as borrowing from other lenders without prior approval by the lender.
Positive covenants are those that represent some type of ratio that must be maintained in order to avoid being in default of your loan. For example, some companies enter into agreements that require that their EBITDA is at a certain percentage of their total outstanding debt. Positive debt covenants are more designed to guide sound business practices than to restrict bad borrowing behavior.
Debt covenants are measured monthly, quarterly, or annually depending on the terms of the agreement. The exact requirements are unique to each loan and need to be assessed and coordinated with the bank. Before entering into a financing agreement be sure that you have a firm understanding on the terms of the covenants and be sure that you can meet the stated covenants in the agreement currently and after stress tests are performed.