A financial covenant requires the business to maintain certain financial metrics, tested periodically — often quarterly or annually for as long as the acquisition loan remains outstanding.
The set of metrics a Canadian acquisition loan typically carries is documented plainly: a debt service coverage ratio testing “whether the business’s cash flow comfortably covers its loan payments”; a leverage ratio, a limit on “how much total debt the business carries relative to its earnings or equity”; a working capital minimum requiring the business to “maintain a certain level of current assets over current liabilities”; and a minimum tangible net worth — “a floor on the business’s net worth after excluding intangible assets like goodwill”.
Financial covenants are a different animal from the operating (negative) covenants sitting alongside them in the same agreement. Financial covenants require holding a number; operating covenants restrict what the business can do without the lender’s consent regardless of how the numbers look — typically barring taking on additional debt, disposing of significant assets, or paying excessive dividends, and granting security interests to a competing lender.
Breach of either kind is treated the same way: the loan agreement defines the breach as an event of default, which typically lets the lender demand repayment of the full loan or move to enforce the general security agreement it holds over the business.
In this loan agreement the lender sets a DSCR floor of 1.30 times tested quarterly and a maximum leverage covenant, both against trailing EBITDA. Two quarters after closing, a soft season pushes EBITDA down enough that DSCR falls to 1.05 times. The DSCR covenant is breached the moment that quarter’s compliance certificate is filed — independent of whether the leverage covenant is still fine — triggering the default clause and putting the lender’s enforcement rights on the table, even though the business is still generating positive cash flow.
See also: debt service coverage ratio, leverage multiple and general security agreement.
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