What is a covenant?
A condition in a loan agreement the borrower must keep meeting. It sits in the contract, not as a line on the Balance Sheet.
Definition
A covenant is a test written into the loan papers that the borrower has to keep passing. On the books, this is a contract rule, not an account you debit or credit.
The lender can freeze draws, raise the rate, or call the remaining principal if the test is failed. Passing it does not create cash, and failing it does not by itself post a journal.
Cash-basis and accrual books both leave this rule off the statements. The Balance Sheet still shows the loan; this condition is the extra promise sitting on that loan.
This condition is not a line you look up in the general ledger. You find it in the agreement, then you prove it with the numbers after each close.
Where it shows up
Balance Sheet: Related to the loan this condition sits on.
P&L: Related to the ratios built from income.
See also: Debt Service Coverage Ratio · Notes Payable · Financial Statement Package
When you look at your Balance Sheet, you will not find this condition as a line. It rides on Notes Payable or on a Line Of Credit, and those loan lines are what the statements show.
A high loan balance does not mean the tests are failed. A low loan balance does not mean the tests are gone; they last as long as the agreement says they last.
The profit and loss statement does not list this condition either. Ratios built from income, such as coverage of principal and interest, are how many of these tests are scored.
On the Statement of Cash Flows, nothing posts for a pass or a fail. Cash still moves when you borrow or repay; the rule itself is not a cash event.
A Financial Statement Package is often what the lender asks for to check the tests. A Debt Schedule then shows which loan the rule is attached to.
How it works
The rule gets into the relationship when you sign the loan. Typical tests include a minimum coverage ratio, a minimum current ratio, a maximum debt-to-equity ratio, or a timely Borrowing Base Certificate.
Those tests are measured after the close, not at the moment you post a sale. The lender uses the statements and the supporting schedules, not a separate account for this condition.
Stay with this condition: it is the pass/fail test, not the loan math. The note or the line still holds remaining principal, and interest still hits the Income Statement.
If you pass, borrowing usually continues as written. If you fail, the lender can stop new draws, ask for a waiver, or call the remaining principal early.
A waiver is a letter, not a journal. The loan stays on the books until you repay it or refinance it.
Some tests are measured every month; some are measured each quarter. Missing a reporting date can be a failure even when the ratios themselves are fine.
Reconcile the proof to the same numbers you issued. A ratio built from a draft that later changed is how shops think they passed when the lender's copy says they did not.
On cash-basis books the ratios can look different because unpaid bills and open invoices are missing. Many agreements still require accrual statements for the test.
Example
A machine shop has an $80,000 note. The agreement says the shop must keep a debt service coverage ratio of at least 1.25.
This year the shop's cash available for debt service is $50,000, and scheduled principal and interest are $40,000. The ratio is 1.25 on the nose, so the test is met.
No journal posts for that result. The $80,000 remains Notes Payable, and the Income Statement still shows the period's interest, not a line for this condition.
If next year cash available fell to $40,000 against the same $40,000 of scheduled service, the ratio would be 1.00. That miss would not write down the note by itself; it would put the shop in default under the agreement.
The shop would then talk to the lender about a waiver or a paydown. Until the note is paid, the condition is still in the papers.
Common mix-ups
A covenant is not the loan. Notes Payable and a Line Of Credit are the amounts owed; this rule is a test those loans have to keep satisfying.
This condition is not a Balance Sheet line. You will not find it between assets and liabilities; you find it in the agreement.
This condition is not the Borrowing Base Certificate. That certificate is a report that can be required by a collateral test; this rule is the requirement itself.
Related terms
- Debt Service Coverage Ratio: Cash available to cover scheduled principal and interest payments.
- Current Ratio: Current assets divided by current liabilities.
- Debt-To-Equity Ratio: Total debt measured against owner equity.
- Line Of Credit: A revolving loan the business can draw on and repay as cash needs change.
- Notes Payable: Formal loan balances owed to a bank or other lender.
- Borrowing Base Certificate: The periodic report submitted to a lender proving eligible collateral.
- Financial Statement Package: The bundled set of statements and schedules delivered after a close.
- Debt Schedule: A supporting schedule tracking each loan's balance, payments, rate, and maturity.