Financial Covenants: How Lenders Think vs How Borrowers Think

Financial covenants are one of those things that sound deeply technical until you sit in a meeting where people are suddenly arguing over them like their lives depend on it. Which, financially speaking, they sometimes do.

Most businesses don’t spend much time thinking about covenants while things are going well. Revenue is healthy, cash is coming in, and everyone assumes next quarter will broadly resemble the last one. Then trading weakens, interest costs jump, or a customer disappears without paying a large invoice, and suddenly half the finance team is staring at a spreadsheet at midnight trying to work out whether leverage still fits inside the agreed limits. And that’s often the point where people start reading the loan agreement properly.

The odd thing about covenants is that both sides genuinely believe they’re being reasonable. Lenders see them as an early warning system. Borrowers see them as restrictions written by people who don’t have to run the business themselves.

Both are right, which is why covenant negotiations rarely stay calm for very long.

Why Covenants Exist

The logic behind covenants is easy enough to follow.

If a business has an incredible year, doubles in size, or suddenly becomes wildly profitable, the lender doesn’t get swept up in the excitement. It still receives its interest payments and expects its money back at the end. That’s the deal.

Because the upside is limited, lenders spend a lot more time worrying about what happens if things go wrong.

That’s where covenants come in.

They’re there to measure financial pressure early enough that there’s still time to fix something. Not after the money’s gone. Not once the business is already falling apart. Earlier than that.

If you’ve read our pieces on Liquidity vs Solvency: Understanding the Difference or Interest and Fees in a Loan Agreement – The Bit Everyone Pretends to Understand, you’ll recognise the same pattern here. Businesses rarely collapse in one dramatic moment. Problems usually arrive slowly at first. Margins tighten. Cash flow gets thinner. Borrowing creeps upwards. Then eventually someone realises the room for error vanished months ago.

Covenants are supposed to stop that drift going unnoticed.

How Lenders See It

Most lenders start with one question:

“What could stop us getting repaid?”

That shapes almost everything else.

A lender looking at a business doesn’t just want to know whether things look fine today. It wants to know what happens if trading weakens, costs rise, or refinancing suddenly becomes difficult six months from now.

That’s why lenders focus so heavily on leverage levels, cash generation and interest cover. They’re trying to work out how much pressure the business can absorb before something breaks.

And despite what borrowers sometimes think, lenders usually aren’t trying to force businesses into default for entertainment purposes. Most lenders would much rather avoid that situation altogether. Defaults are expensive, messy and time-consuming. They involve lawyers, emergency calls, revised forecasts and a great deal of pretending everyone remains calm while clearly not remaining calm.

What lenders really want is enough warning to do something useful before the situation becomes unmanageable. Maybe costs get cut, distributions stop for a while, or fresh equity comes in before the situation gets uglier.

But once cash genuinely starts running out, those options narrow very quickly.

That’s the fear sitting underneath most covenant discussions, even if nobody phrases it quite so directly.

How Borrowers See It

Borrowers experience the same covenant package very differently. Management teams are trying to run the business, keep customers happy, deal with rising costs, make investment decisions and avoid spending half the week on calls explaining why this month’s numbers look worse than last month’s.

From inside the business, covenants rarely feel as reasonable as lenders think they are. More often, they feel like extra pressure added by people who would ideally like the business to operate in a world where nothing unexpected ever happens.

And borrowers feel the effect of those covenants much more directly than lenders do.

A leverage covenant can suddenly restrict expansion plans. Liquidity requirements can trap cash inside the business when management wants flexibility elsewhere. Reporting obligations sound perfectly harmless until somebody has to produce them while also trying to keep the business functioning during a difficult quarter.

And then there’s the emotional part people rarely say out loud.

Borrowers often feel lenders judge the business using the bleakest possible reading of the numbers. Lenders often feel borrowers explain away every warning sign as temporary.

That’s why covenant discussions can become oddly personal, even in rooms full of very corporate people pretending otherwise.

Where Things Usually Become Uncomfortable

Leverage covenants are often the biggest source of tension.

Lenders like them because they force a direct conversation about debt levels: is there too much borrowing for the amount of profit this business produces? Borrowers dislike them because businesses have an annoying habit of refusing to behave exactly as planned.

A company investing heavily for growth can suddenly look over-leveraged during a difficult period even if management still feels confident about the long-term picture. Seasonalbusinesses can look perfectly stable right up until the part of the year where all the money is supposed to arrive… and doesn’t.

That’s usually when the arguments over EBITDA start.

Management talks about temporary costs, future savings and one-off issues that “distort the numbers.” Lenders start becoming deeply suspicious of anything described as temporary for the third quarter in a row. Somewhere in the middle sits a spreadsheet full of add-backs that everybody studies very carefully while pretending not to be slightly irritated by it.

Interest cover creates a different sort of tension because the focus shifts towards cash flow. Can the business comfortably afford its interest bill?

These conversations became far more awkward once interest rates started climbing sharply. Borrowers suddenly found themselves pointing out, with some justification, that the financing itself had started becoming part of the problem. Lenders, meanwhile, were looking at the same numbers and wondering how much room was left if rates stayed higher for longer than everybody hoped.

That’s normally the point where the tone of the conversation changes.

Negotiation Points That Matter

Most covenant negotiations are really arguments about headroom.

Lenders want enough room so that a breach means something has genuinely deteriorated, not just that trading had a slightly messy quarter. Borrowers want enough flexibility to avoid spending their lives requesting waivers every time the business hits a patch of volatility.

That sounds straightforward until everyone starts trying to define what “normal volatility” means.

A covenant package that is too tight becomes exhausting very quickly. Management starts treating the reporting process like a monthly ambush, and lenders end up buried under repeated consent requests for issues that are more irritating than dangerous.

But covenants that are too loose create a different problem. Everything can appear perfectly compliant right up until the moment everybody suddenly realises the room for manoeuvre disappeared months earlier.

And once a breach or near-breach appears, the relationship often changes quite quickly.

Lenders start asking harder questions. Forecasts get challenged more aggressively. Borrowers become wary that every discussion is quietly turning into a negotiation about control. Even routine decisions can suddenly start carrying approval conditions, revised reporting requirements or requests for fresh equity support attached to them.

That does not mean every covenant issue turns into a restructuring.

But it does explain why people pay such close attention to them once the numbers start moving the wrong way.

What a Good Covenant Package Looks Like

The covenant packages that work best are usually not the ones trying to monitor every possible movement in the business like a nervous parent tracking their teenager’s phone location.

They’re the ones that broadly reflect how the business genuinely behaves.

A stable infrastructure business should not have the same covenant pressure as a cyclical retailer. A company halfway through a heavy expansion phase will naturally look different from one that has spent ten years quietly generating cash and paying dividends. Problems start when documents assume every business produces smooth, predictable numbers all year round, because very few real businesses behave like that for long.

The strongest covenant packages are usually the ones both sides can explain in plain English without sounding like they are reading from a tax manual.

What risk is this covenant supposed to monitor?
What happens if it gets breached?
Does the ratio genuinely tell us something useful about the health of the business?

If nobody can answer those questions clearly, there’s a fair chance the covenant exists because it appeared in the last financing rather than because anybody particularly needed it here.

The Last Word

Most businesses don’t collapse because of a covenant breach.

Usually, the breach is just the moment everybody stops pretending the pressure is temporary.

That’s why covenants create so much tension in the first place. They force lenders and borrowers to look at the same business through completely different lenses at exactly the moment nobody feels particularly relaxed about the numbers.

For lenders, the question is how early they can spot a problem before value disappears.

For borrowers, the question is how much flexibility a business needs before normal commercial volatility starts being treated like financial distress.

And somewhere between those two positions sits the negotiation that keeps finance teams awake at midnight staring at spreadsheets they were hoping not to open again until next quarter.