Business Loan Covenants: ICR, DSCR and LVR Tests and What a Breach Means

In short: A covenant is a promise in your facility agreement to keep certain numbers inside agreed limits and to report on time. In business loans and commercial property loans the usual financial tests are interest cover (ICR), debt service cover (DSCR) and loan-to-value (LVR). A breach rarely means the loan is called in at once: it usually gives the lender rights to review, reprice, ask for more security or, eventually, act on a default.

Key takeaways

The definitions decide the result: which earnings, which interest, which valuation, and whether the test runs on a rolling 12 months.
On an amortising loan the DSCR usually binds well before the ICR, because principal sits in the denominator.
A lender-ordered revaluation can breach an LVR covenant without you borrowing another dollar.
For a Small Business loan from a bank that subscribes to the Banking Code, financial covenants can trigger default action only on property development and listed specialised loans.
Negotiate headroom, cure rights and testing dates before you sign; tell the lender early if a test will fail.

What is a business loan covenant, and what kinds will you see?

A covenant is a term of the loan contract in which the borrower promises to do something, not to do something, or to keep a financial measure inside a limit. A loan is priced on a picture of the business at the credit decision; covenants tell the lender, during the term, whether that picture still holds.

Type	Typical example (illustrative limits)	What it protects the lender against
Financial	ICR of at least 2.0 times; DSCR of at least 1.25 times; LVR of no more than 65%	Earnings or security value falling below what the loan was sized on
Reporting	Annual accounts within a set number of days of year end; half-yearly management accounts; a compliance certificate signed by a director	Finding out about trouble too late
Negative	No further security over the assets (a negative pledge); no dividends or director loans without consent; no change of control	Value leaving the business, or another creditor ranking ahead
General	Keep insurance and licences current; notify litigation or ATO arrears	The business losing its ability to trade

Covenants multiply as loan size grows: a $150,000 term loan may carry little beyond a promise to provide accounts on request, while a $3 million facility over a warehouse and a trading business may carry four financial tests. Business.gov.au's business loan guidance notes that lenders assess the financial health of a business before they lend. Covenants are that same assessment repeated every six or twelve months for the life of the loan.

How is the interest cover ratio calculated?

The interest cover ratio (ICR) asks how many times earnings cover the interest bill. The usual formula is earnings before interest and tax (EBIT) divided by interest expense, though some agreements use EBITDA (earnings before interest, tax, depreciation and amortisation). Which one your contract uses changes the answer.

Worked example (illustrative figures). A manufacturing business reports EBITDA of $620,000. Depreciation is $120,000, so EBIT is $500,000. Interest on all of its debt is $160,000.

ICR on EBIT: $500,000 / $160,000 = 3.13 times.
ICR on EBITDA: $620,000 / $160,000 = 3.88 times.

Against a minimum ICR of 2.0 times on EBIT, the business breaches when EBIT falls below $320,000 (2.0 x $160,000): a fall of $180,000, or 36%. That looks comfortable, but interest is the other half of the ratio. On a variable-rate facility a rate rise lands straight in the denominator. The RBA's cash rate target table shows the target was 4.60% from 30 September 2026, and every change from there moves your ICR without anything changing inside the business.

For a commercial property investment loan, ICR is tested on net rent instead of trading earnings. A property earning $180,000 a year net, with a $2,000,000 loan at an illustrative 7.5% (an example, not an offer), pays $150,000 of interest and has an ICR of 1.2 times. Our guide to commercial property loan LVRs and lease doc lending explains how lenders read the lease behind that rent.

How is the debt service coverage ratio calculated?

The debt service coverage ratio (DSCR) asks whether cash earnings cover the whole repayment, interest and principal. A common form is (EBITDA minus tax paid minus maintenance capital expenditure) divided by (interest plus scheduled principal). Some lenders use EBITDA straight; some also deduct owners' drawings or put lease payments in the debt service line.

Worked example, continued. The same business paid $90,000 of tax and spent $50,000 keeping its machines running.

Cash available for debt service: $620,000 - $90,000 - $50,000 = $480,000.
Debt service: $160,000 interest + $200,000 scheduled principal = $360,000.
DSCR: $480,000 / $360,000 = 1.33 times.

Against a minimum DSCR of 1.25 times, the business needs $450,000 of cash available (1.25 x $360,000). Its headroom is $30,000, or 6.25% of cash available, compared with the 36% fall in EBIT the ICR could absorb. That is the pattern to remember: on an amortising business loan the DSCR usually binds first, because principal sits in the denominator. Stretching the term or adding a balloon reduces scheduled principal and widens DSCR headroom, at the cost of more interest overall; the trade-offs are set out in business loan amortisation vs balloon payments.

You can test your own figures, and see the maximum loan each ratio supports, in the ICR and DSCR calculator.

How is an LVR covenant tested, and how can a revaluation breach it?

An LVR covenant compares the loan balance with the lender's valuation of the security. Most commercial facility agreements let the lender order a fresh valuation at set intervals, or whenever it reasonably believes the value has fallen, and many make the borrower pay for it. Commercial property is valued largely by capitalising net income, so a change in the valuer's capitalisation rate moves the value even when the rent has not changed.

Illustrative example	At the credit decision	At the next revaluation
Net rent	$180,000	$180,000
Capitalisation rate used by the valuer	5.625%	6.25%
Value (net rent / cap rate)	$3,200,000	$2,880,000
Loan	$2,000,000	$2,000,000
LVR (covenant maximum 65%)	62.5%	69.4% - breach

To bring the LVR back to 65%, the loan must fall to $1,872,000 (65% x $2,880,000), which means a principal reduction of $128,000. The other usual cures are extra security, such as a second property, or a term deposit charged to the lender. The LVR and equity worked calculations post shows the same arithmetic for combining securities.

Check how often the lender can revalue, and who chooses the valuer.

Why do reporting covenants catch out more borrowers than the ratios?

Many breaches are not ratio failures at all. They are late accounts, an unsigned compliance certificate, or an ATO payment plan the lender learns about from a credit file. The external accountant who prepares the reports is rarely the person who signed the loan.

Report	Typical timing (indicative, varies by lender)	Common failure
Annual financial statements	Within roughly 120 to 180 days of year end	The accountant's lodgement program runs later than the loan deadline
Compliance certificate	With the annual or half-yearly accounts	Nobody at the business knows the covenant definitions
Management accounts and aged debtors	Quarterly or half-yearly on larger facilities	Unreconciled figures that later differ from the annuals
Tax position	On request, or with the annual review	A payment plan or lodgement backlog not disclosed
Insurance certificate of currency	At each renewal	Cover lapses or the lender is not noted as an interested party

Keep a covenant calendar listing each report, its due date and who signs, and give your accountant the deadlines in writing.

What actually happens when you breach a covenant?

Lender options run from mild to severe:

Review event. The lender may continue, reprice, ask for security or a paydown, or give notice to exit.
Waiver. The lender agrees not to act on this breach, often for a fee: for illustration, 0.25% of a $2,000,000 limit is $5,000.
Reset. The covenant is rewritten, often with a margin increase. An extra 0.50% a year on $2,000,000 costs $10,000 a year.
Event of default. The lender can demand repayment and then enforce its security.

Who the lender is matters. The 2025 Banking Code of Practice gives extra protection to a "Small Business" (turnover under $10 million in the previous financial year, fewer than 100 full-time equivalent employees, and under $5 million of total debt to all credit providers, all three tests) borrowing from a bank that subscribes to it. Under the Code, as read on 24 October 2026:

financial indicator covenants can be a trigger for default action only on loans for property development and on listed specialised lending, such as margin lending, loans to SMSFs, bailment, invoice discounting, construction lending, foreign currency loans and tailored cash flow lending (paragraph 91);
standard form small business loans cannot include a default event based on an unspecified material adverse change (paragraph 92);
for the listed non-payment defaults, which include failing to provide required financial information, the bank gives written grounds and at least 30 days to remedy a default that can be remedied (paragraph 88), and acts only where the default is material (paragraph 90);
if the bank decides not to extend a loan at maturity, it gives at least three months' notice (paragraph 93).

Non-bank and private lenders are not bound by the Banking Code unless they adopt it, and their documents often carry wider default events, material adverse change clauses, shorter cure periods and default interest. Read that clause line by line.

How do you negotiate covenant headroom before you sign?

Headroom is the distance between where a ratio sits today and where it breaches. Using the examples above:

Covenant	Limit	Today	How far it can move before breach
ICR (EBIT / interest)	At least 2.0 times	3.13 times	EBIT can fall $180,000 (36%)
DSCR	At least 1.25 times	1.33 times	Cash available can fall $30,000 (6.25%)
LVR	No more than 65%	62.5%	Value can fall $123,077 (3.85%), a cap rate move from 5.625% to 5.85%

The DSCR and LVR here are fragile. Before signing, model a fall in earnings and a rate rise of at least one percentage point, check that no covenant fails, then negotiate:

The definitions. Agree add-backs for one-off costs, how owners' remuneration is treated, and whether tests use a rolling 12 months.
Testing dates. A seasonal business should be tested on annual figures, not an annualised slow quarter.
Cure rights. An equity cure lets shareholders inject cash that counts toward the test, usually a limited number of times.
A lock-up level. A dividend stop set above the default level warns both sides early.
Revaluation limits. Frequency, valuer choice and your right to a copy of the report.

Remember who stands behind the company. If directors have signed personal guarantees, a covenant breach that becomes a default reaches their own assets; directors' guarantees explained covers what those documents allow.

What should you do when a covenant test is going to fail?

Lenders respond far better to a call before the test date than to a late certificate with a breach in it.

Run the numbers early. Recalculate every covenant from the management accounts a quarter before each test date.
Tell the lender first. Explain the cause and the fix.
Bring a forecast. A 12-month cash flow forecast showing when the ratio recovers carries more weight than reassurance; see cash flow forecasts lenders accept.
Ask for something specific. A one-off waiver, a reset for two test dates, or a temporary step-down in principal repayments.
Never sign a compliance certificate you know is wrong. Materially incorrect information is itself a default under most contracts.

Directors should also read covenant pressure as a warning light. ASIC's page on insolvency for directors lists maxed-out overdrafts, missed loan payments and closer lender scrutiny among the warning signs, alongside the duty to prevent the company trading while insolvent. If the covenants never fitted the business, a refinance may be the answer: when you are ready, post one business loan request on ADS and 200+ verified lenders and brokers can ask about it. Speak to your accountant and a lawyer before you agree to any reset or waiver.

Frequently asked questions

What is a typical DSCR covenant on a business loan?

Minimum DSCR covenants on trading business loans often sit around 1.25 to 1.5 times, but that range is indicative and varies by lender, industry and loan type. The definition matters as much as the number: a 1.25 times test after tax and maintenance capex is tighter than one on raw EBITDA.

Is breaching a loan covenant the same as defaulting?

Not necessarily. Many agreements treat a financial covenant breach as a review event, letting the lender reprice, ask for security or decline to continue rather than demand repayment. Others make any breach an event of default. Your facility agreement, and for small business bank loans the Banking Code, decides which.

Can a bank call in my business loan after a bad year?

It depends on the contract and the lender. For a Small Business on a standard form loan from a bank that subscribes to the Banking Code, financial indicator covenants can trigger default only for property development and listed specialised loans. The bank can still decline to extend at maturity, with at least three months notice.

What is an equity cure?

An equity cure lets shareholders fix a covenant breach by putting money into the business. The cash counts as extra earnings for the test, or reduces the loan. Lenders usually limit how often it can be used, so it buys time rather than fixing a structural problem.

Do I have to tell my lender about a covenant breach?

Usually yes. Most facility agreements require you to notify the lender of any breach and to deliver a compliance certificate stating whether each covenant was met. Hiding a breach, or certifying compliance you know is false, is typically a separate default and does more damage than the original breach.

Sources

Business loan guidance — business.gov.au
Cash rate target (4.60% from 30 September 2026) — Reserve Bank of Australia
Insolvency for directors: warning signs and the duty to prevent insolvent trading — Australian Securities and Investments Commission
Banking Code of Practice 2025: small business definition, default events and covenants (paragraphs 87-93) — Australian Banking Association

Information current as at 24 October 2026.

General advice warning: This article contains general information only. It does not take into account your objectives, financial situation or needs, and it is not personal credit or financial advice. Consider whether it is appropriate for you and seek advice from a licensed credit representative before acting.

Any interest rate shown is an example only and is not an offer of credit. Where a rate is quoted, the applicable comparison rate is available from the relevant lender and should be considered alongside it.