Quick answer
A covenant is a promise written into a loan agreement that the borrower must keep for as long as the loan runs. Some covenants are financial, such as keeping profit at a set multiple of repayments. Others govern behaviour, such as sending accounts each year or not borrowing elsewhere without consent. Breaching a covenant can count as a default even when every repayment has been made on time.
Key points
- Financial covenants test numbers like debt service cover or loan-to-value; behavioural covenants govern what you must or mustn't do
- A breach can be a default even if no repayment has been missed
- The 2025 Banking Code limits financial indicator covenants to specialised small business loans, such as property development
- Read the covenant schedule in your letter of offer before you sign, and diarise every reporting date
Repayments are the obvious obligation in any loan. Covenants are the rest of the deal: the conditions a borrower agrees to keep meeting after the money lands, written into the loan agreement and usually summarised in the letter of offer. They let a lender keep an eye on risk between repayments, and they’re the part of the paperwork owners most often skim.
What kinds of covenants do lenders use?
Covenants fall into two broad families. Financial covenants are tests a set of numbers must pass, normally checked when your annual accounts arrive. Behavioural covenants (sometimes called general or undertaking covenants) describe things you must do or must avoid.
| Type | What it measures or requires | Typical example |
|---|---|---|
| Debt service cover | Profit available to meet repayments | Cash profit at least 1.25 times annual loan repayments |
| Interest cover | Earnings against interest cost | Earnings before interest and tax at least twice the interest bill |
| Loan-to-value | Debt against the security’s value | Loan no more than 65% of the property’s valuation |
| Reporting | Information the lender receives | Annual accounts within 120 days of 30 June |
| Positive undertaking | Something you must do | Keep the secured building insured and rates paid |
| Negative undertaking | Something you mustn’t do without consent | No further borrowing, no sale of secured assets, no change of control |
The debt service coverage ratio is the financial test owners meet most often, and a loan-to-value ratio covenant is common wherever property is the security.
What does the Banking Code say about covenants?
This is where the Australian picture differs from what many owners expect. After the Small Business Ombudsman’s review of loan contracts, the major banks agreed in 2017 to stop putting financial indicator covenants into most small business loans. The 2025 Banking Code of Practice now sets the rule for subscribing banks: financial indicator covenants, or covenants tailored to the deal, are allowed only in certain specialised loans, such as property development and margin lending. That version of the Code raised its small business ceiling to total borrowing under $5m, bringing roughly 10,000 more businesses inside those protections.
Two further limits matter. A standard small business loan contract can’t make an unspecified “material adverse change” an event of default. And before acting on most non-payment defaults, the bank must give written notice and at least 30 days to put things right, where the problem can be fixed.
Non-bank lenders aren’t automatically bound by the Banking Code, so their covenants come down to the contract you sign. Larger corporate facilities above the small business threshold still commonly carry full financial covenant packages.
Worked example: a covenant breach with no missed repayment
A Geelong food manufacturer borrows $1.2m to fund a factory and production line, secured over the property. Because the borrowing group’s total debt is above the Code’s small business threshold, the facility includes a debt service cover covenant of 1.25 times, tested each year on audited accounts due by 31 October.
In one year a contract loss pushes cash profit down. Annual repayments are $180k, so the business needs at least $225k of cash profit to pass. It produces $205k, a ratio of about 1.14 times. Every repayment has gone out on the due date, yet the covenant is breached.
What happens next is usually a discussion rather than an emergency. The owner sends a forecast showing a new contract starting in March, and the lender agrees to waive the test for that year in exchange for quarterly management accounts until the ratio recovers. Had the owner hidden the shortfall until the accounts were overdue, that would have been a second breach, of the reporting covenant, and a harder conversation.
If covenants have already cost you a facility, our declined by the bank page sets out the alternatives, or you can send us the details and we’ll look at your options.
Related terms
- Loan covenant: the same idea, as it appears in a specific facility
- Default: what a serious covenant breach can trigger
- General security agreement: often carries its own negative covenants over business assets
- Serviceability: the capacity test that financial covenants keep checking after settlement
Need a loan with terms you can live with?
Covenants are easier to manage when the facility fits the business in the first place. Before you sign anything, run your numbers through our debt service coverage ratio calculator to see how much headroom you’d have. Then, if you want a hand finding the right lender, the enquiry takes roughly sixty seconds. Nobody runs a credit check when it arrives, and we don’t fire your file off to every funder we know. One of our team, a human being, reads it and rings you to work through the covenant question with you. Honest turnover and debt figures mean the first facility we raise should be one your accounts can pass each year.
Frequently asked questions
What is the difference between a positive and a negative covenant?
A positive covenant is something you must do, such as keep the property insured, lodge your tax returns or send annual financial statements. A negative covenant is something you must not do without the lender's consent, such as sell the secured asset, take on more debt or change who owns the company.
Do small business loans from banks still have financial covenants?
Mostly not. Under the 2025 Banking Code of Practice, banks that subscribe to it can include financial indicator covenants only in certain specialised small business loans, such as property development finance and margin lending. Standard small business loans can't include a default based on an unspecified material adverse change.
What happens if I breach a covenant?
It depends on the loan terms and the lender. Many lenders start with a conversation and may waive the breach, reprice the loan or ask for more security. Banks bound by the Banking Code generally must give written notice and at least 30 days to fix a remediable breach before acting on it.
Do non-bank and private lenders use covenants?
Yes, though usually simpler ones. Short-term and private lenders tend to rely on security and a clear exit date rather than ongoing financial tests. Their agreements still contain behavioural covenants, such as keeping insurance current and not further encumbering the property.
Can I negotiate a covenant?
Often, before you sign. Thresholds, testing frequency and the time allowed to deliver accounts are all common points of negotiation, particularly on larger facilities. Your accountant can tell you whether a proposed test leaves enough headroom in a weak year.