For any SME (Small and Medium Enterprise), securing a business loan is a significant milestone. Whether the loan is for working capital, machinery purchase, project expansion, or general corporate purposes, the terms laid out in the sanction letter define the foundation of the relationship between the borrower and the lender.
Among the most critical — and often overlooked — components of a sanction letter are covenants.
What Are Covenants?
Covenants are legally binding clauses in a loan agreement that impose certain conditions, restrictions, or obligations on the borrower. They are designed to protect the lender’s interests and ensure that the borrower’s financial health, conduct, and operations remain within acceptable limits throughout the loan tenure.
Covenants may be:
Affirmative (Positive) – actions the borrower must take
Negative (Restrictive) – actions the borrower must not take
Financial – metrics the borrower must maintain
For SME borrowers, understanding and managing these covenants is essential to avoid breaches, penalties, or loan recalls.
Types of Covenants – Explained
Affirmative Covenants – What You Must Do
These clauses list activities or standards the borrower must adhere to during the life of the loan. Common affirmative covenants include:
Timely Submission of Documents
Borrowers must regularly submit:
- Stock and receivable statements (for CC/OD accounts)
- Audited financials
- Provisional profit & loss and balance sheet (quarterly or semi-annually)
- GST returns or ITRs
Failing to submit these on time may result in a reduction of drawing power, increased scrutiny, or penalties. These penalties may lead to unnecessary financial costs on the borrower. That is why at Bankkeping we are so focused on timely compliance with Banks.
Maintaining Adequate Insurance
Assets given as security (e.g., plant, property, inventory) must be insured against risks such as fire, theft, and natural calamities — with the bank as the beneficiary. Borrowers must renew and submit proof of insurance periodically. Failure to take or submit Insurance documents may also lead to Penal charges.
Use of Funds for Stated Purpose
The borrower must ensure that the loan amount is used strictly for the sanctioned purpose. Diverting funds can lead to legal consequences and immediate recall of the facility. There maybe many more covenants imposed by the Banker. Remember each sanction letter is a customised one and some of these terms are decided basis how you negotiate with Banks.
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Negative Covenants – What You Must Not Do
These clauses place restrictions on the borrower’s actions to prevent increased risk for the lender. Typical negative covenants include:
No Additional Borrowings Without Consent
The borrower cannot take on additional debt (from banks, NBFCs, or private sources) without the existing lender’s prior approval. This ensures the borrower doesn’t become over-leveraged.
No Change in Capital Structure
Changes in shareholding, promoter stake, or infusion of equity without the bank’s consent may be prohibited, particularly in term loan agreements.
No Dividend Declaration Without Approval
Especially relevant for companies, this clause restricts dividend payments until all dues and covenants are met.
No Major Capital Expenditure
Significant investments in new assets or projects may require prior bank approval, particularly if they could impact cash flow or increase operational risk.
No Repayment of Unsecured Loan taken from Directors
Banks create provision that unsecured loans taken from Directors cannot be returned without a proper NOC from the Banks
Financial Covenants – Numbers You Must Maintain
These are measurable parameters that the borrower is required to meet throughout the loan term. Some of the most common financial covenants include:
Debt Service Coverage Ratio (DSCR)
Measures the company’s ability to repay its loan obligations (typically required to be above 1.25x).
Formula:
DSCR = Net Operating Income / Total Debt Service
Current Ratio
A measure of liquidity, typically required to be above 1.25 or 1.33.
Formula:
Current Ratio = Current Assets / Current Liabilities
Total Outside Liabilities to Tangible Net Worth (TOL/TNW)
Used to assess overall leverage; often required to be below 4:1 or 3:1.
Interest Coverage Ratio
Indicates the company’s ability to pay interest from earnings (EBIT/Interest). A healthy ratio is typically above 2.5. There maybe many more and different kinds of Financial Covenants imposed by Banks, the above are just few examples.
Consequences of Breach
A breach of covenants — intentional or otherwise — can trigger a loan default, even if the borrower is servicing EMIs or interest on time. Consequences may include:
- Increase in interest rate (penal interest)
- Freezing of further disbursements
- Reduction of working capital limits
- Recall of the loan
- Impact on credit rating or eligibility for future borrowing
What SME Borrowers Should Do
Covenants are not mere formalities. They are dynamic obligations that must be monitored and complied with consistently. Here’s how SME borrowers can protect themselves:
Understand Before You Sign
Ask your banker or advisor to explain every covenant. If you feel certain conditions are too stringent or unrealistic, negotiate upfront before accepting the sanction.
Track Covenants Proactively
Use tools or platforms (like Bankkeeping) to track key ratios, submission timelines, and alerts. Automation ensures that you never miss a deadline or breach unintentionally.
Keep Communication Open
If you’re likely to breach a covenant (say, due to a poor quarter or sudden capex), inform the bank proactively and request a waiver or temporary relaxation.
Keep Records Clean
Ensure your books of accounts, MIS reports, GST filings, and audits are always up to date and accessible. Most covenant checks rely on these.
Common Mistakes to Avoid
- Signing the sanction letter without reading the annexures or schedule of covenants
- Assuming covenants are boilerplate and not enforced
- Submitting incomplete or inaccurate data to the bank
- Ignoring monthly/quarterly compliance submissions
- Overlooking DSCR or other ratio changes due to shifting business conditions
Final Thoughts
Loan covenants are not meant to trap borrowers — they exist to provide structure, discipline, and transparency in the lender-borrower relationship. For SMEs, being covenant-compliant not only ensures financial health but also builds credibility for future fundraising and credit line expansions. Rather than fear them, treat covenants as guardrails for responsible borrowing. When monitored properly, they help SMEs manage debt more efficiently and grow with confidence. If you are struggling with managing covenants, or you know anyone who is struggling – we recommend
adopting Bankkeeping, the only solution of its kind and which will help you constantly monitor your Covenants.