Loan Covenant Health Check

What does a loan covenant health check test?

Financial covenants are the ratio tests written into a commercial loan agreement. This health check computes the three that appear most often for small and mid-sized borrowers: a coverage covenant (debt service coverage ratio, DSCR), a leverage covenant (total debt to EBITDA), and a liquidity covenant (current ratio). It then compares each to a reference threshold so you can see which test is closest to failing.

The reference thresholds in the calculator are placeholders, not your terms. Replace them mentally with the numbers in your own credit agreement — the definitions and floors are negotiated loan by loan.

The formula

DSCR = EBITDA ÷ annual debt service; leverage = total debt ÷ EBITDA; current ratio = current assets ÷ current liabilities

• DSCR is a minimum test: higher is better. Debt service is principal plus interest on all business debt.
• Leverage is a maximum test: lower is better. It shows how many years of EBITDA it would take to repay all debt.
• Current ratio is a minimum test: it compares assets that turn into cash within a year with obligations due within a year.

Worked example

Illustrative example — a hypothetical services company tested against illustrative covenant terms of DSCR ≥ 1.25x, leverage ≤ 3.50x and current ratio ≥ 1.20:

1. EBITDA $2,400,000; debt service $1,500,000 → DSCR = 2,400,000 ÷ 1,500,000 = 1.60x (passes).
2. Total debt $7,800,000 → leverage = 7,800,000 ÷ 2,400,000 = 3.25x (passes).
3. Current assets $1,900,000; current liabilities $1,250,000 → current ratio = 1.52 (passes).
4. EBITDA that would breach DSCR: 1.25 × $1,500,000 = $1,875,000, a fall of $525,000 (21.9%).
5. EBITDA that would breach leverage: $7,800,000 ÷ 3.50 = about $2,228,571, a fall of about $171,429 (7.1%).

All three tests pass, but they do not have equal room. The leverage covenant breaches after a 7.1% EBITDA decline, three times sooner than the coverage covenant. The binding constraint is the one with the least headroom, not the one with the lowest ratio.

How to read your result

Pass / close / fail labels are only a first pass. The more useful read is which covenant is tightest and how much EBITDA, debt, or working capital movement would trip it.

EBITDA sits in two of the three formulas, so a decline in earnings hits coverage and leverage at the same time. A business with modest room on both can move from comfortable to double breach in one bad quarter.

Liquidity moves faster than the others: paying down a payable or collecting a receivable changes the current ratio overnight, while DSCR and leverage usually move with trailing-twelve-month earnings.

Thresholds vary by lender, loan type and industry. For one published reference, the SBA's 7(a) Small Loan rules require DSCR of at least 1.10:1 at underwriting (SBA Procedural Notice 5000-876777).

Common mistakes

• Using reference thresholds instead of your agreement. Your credit agreement defines each ratio and its limit. A ratio that passes a generic threshold can still fail yours.
• Classifying the current portion of long-term debt as long-term. Principal due within twelve months is a current liability. Leaving it out flatters the current ratio.
• Testing year-end only. Seasonal businesses can look fine at year-end and breach mid-year. Test at every covenant measurement date, and ideally monthly.
• Forgetting EBITDA adjustments. Covenant EBITDA is often adjusted (add-backs allowed, certain items excluded). Use the agreement's definition consistently in both DSCR and leverage.

Frequently asked questions

Further reading

• The 90-day plan for a new CFO inheriting a mess — Step one for a new finance lead: find out which covenants exist and how close they are.
• Finance integration after an acquisition: the first 100 days — Combining two companies' debt and EBITDA changes every covenant test overnight.
• Upskilling your finance team for the AI era — Automated checks still need someone who can tell when a covenant number is wrong.
• HealthGuard vs Fathom — Comparing two ways to keep financial-health ratios in front of you.

More free tools

• Cash Runway Calculator
• DSO & AR Aging Calculator
• Gross Margin Analyzer
• 13-Week Cash Flow Starter
• DSCR Calculator
• Covenant Headroom Checker

Sources

• SBA Procedural Notice 5000-876777, revising SOP 50 10 8 (effective March 1, 2026; copy hosted by NAGGL)

Worked examples on this page are illustrative and use hypothetical figures, not customer data. This page is general information, not lending, tax or investment advice.