Financial covenants are fixed rules written into loan agreements. They define which financial conditions a company has to meet throughout the life of a loan. Covenants play an important role in corporate finance and come up regularly in interviews for investment banking, private equity, and venture capital.
This article explains financial covenants from the ground up, step by step. You’ll learn what the term actually means, why covenants exist, and how they work in practice.
In simple terms, financial covenants are financial rules a company has to follow after taking on a loan. They are part of the loan agreement and define how the company is expected to perform financially while the loan is outstanding. These rules are based on clearly defined financial metrics from the financial statements or cash flow and are reviewed regularly, usually on a quarterly basis.
A quick example: A company takes out a loan and commits to keeping its debt below a certain limit. At each testing date, it is checked whether this limit is still met. If the company exceeds it, this is called a covenant breach. What that means in practice is explained in the next section.
A covenant breach means that a company has violated an agreed rule in its loan agreement. This does not automatically mean a default. Instead, it signals that the company’s financial situation has worsened and that a discussion with lenders is needed.
In practice, a covenant breach usually leads to negotiations between the company and its lenders. Common outcomes include higher interest rates, stricter terms, or a fee (often called a waiver fee) that allows the company to buy more time. Only in severe cases do lenders demand immediate repayment of the loan. For investors, a breach can mean that additional equity is required or that the business plan needs to be adjusted.
When a company takes on a loan, lenders provide capital without being able to manage the business day to day. Financial covenants help make this risk more manageable. They ensure that financial problems do not build up unnoticed but are identified early on.
The main benefits of financial covenants are:
In general, financial covenants can be divided into two main categories. The key difference is when they are tested and when they apply.
Maintenance covenants must be met on a regular basis, usually quarterly. Regardless of what the company is planning at the time, it is checked whether certain financial metrics are still within the agreed limits.
Typical examples include limits on maximum leverage or minimum interest coverage. If EBITDA declines or debt increases too much, a covenant can be breached.
Incurrence covenants are not tested regularly. They only apply when a company wants to take a specific action, such as raising additional debt.
The logic is simple. The company is only allowed to take this action if it still meets the agreed financial limits after the transaction. This prevents the company from becoming overly leveraged through individual decisions.
Incurrence covenants are typical for high yield bonds and unitranche financings, where companies have more flexibility in day-to-day operations but face restrictions on major decisions.
In addition to financial covenants, loan agreements also include affirmative and negative covenants. Affirmative covenants define what a company must do, such as providing regular financial reports or complying with laws and regulations. Negative covenants define what a company is not allowed to do, such as selling major assets or taking on additional obligations without lender approval.
These covenants are part of almost every loan agreement, but usually not the focus in finance interviews. The emphasis is typically on financial covenants.
In practice, there are many possible financial covenants. In finance interviews, however, only a small number of key metrics are usually tested.
The following covenants are among the most important in investment banking, private equity, and leveraged finance, each with a simple rule of thumb to help you remember them.
The maximum leverage ratio limits how much debt a company is allowed to have relative to its operating performance. The lower the permitted ratio, the more conservative the financing structure.
Rule of thumb: How much debt can the company afford?
The minimum interest coverage ratio ensures that the company can pay its interest expenses from operating earnings. If the ratio falls too low, interest costs start to become a burden.
Rule of thumb: Are operating earnings sufficient to cover interest payments?
The minimum fixed charge coverage ratio checks whether operating cash flow is sufficient to cover all fixed payments. This includes not only interest, but also lease payments or fixed amortization.
Rule of thumb: Is cash flow enough to cover all recurring fixed obligations?
The minimum liquidity covenant requires the company to maintain a minimum level of cash or available liquidity at all times.
Rule of thumb: Is there enough cash on hand to remain liquid in the short term?
The debt service coverage ratio measures whether ongoing cash flow is sufficient to actually pay interest and principal repayments.
Rule of thumb: Can the company truly service its debt?
Below are three common interview questions with short and clear answers to help you prepare for finance interviews.
Financial covenants are financial rules written into loan agreements that define which key metrics a company must meet during the life of a loan. They help lenders identify early if a company’s financial situation is deteriorating and whether the repayment of the loan could be at risk.
Maintenance covenants are tested regularly, usually on a quarterly basis, and must be met at every testing date. Incurrence covenants only apply when a company plans to take a specific action, such as raising additional debt or paying dividends. Maintenance covenants are therefore stricter and leave the company with less ongoing flexibility.
Higher leverage increases the risk for lenders, because even small declines in earnings can become problematic. Stricter covenants ensure that financial issues become visible at an early stage and allow lenders to intervene in time.
Financial covenants are financial rules built into loan agreements that allow lenders to monitor how a company performs during the life of a loan. They are based on defined metrics such as leverage, interest coverage, cash flow, and liquidity and are usually tested on a regular basis. A covenant breach is not an immediate default, but an important early warning signal that triggers discussions and adjustments. This is why financial covenants play a central role in corporate finance.
For interviews in investment banking, private equity, and leveraged finance, the most important covenants to focus on are leverage ratio, interest coverage, fixed charge coverage, liquidity, and debt service coverage. What matters is not just being able to define them, but understanding their underlying purpose. How much risk is there? Can the company meet its payment obligations and remain financially flexible? Candidates who understand this logic and can explain covenants using simple examples demonstrate real understanding rather than memorized knowledge.
