A financial covenant is an agreed-upon condition outlined in loan or credit agreements between lenders and borrowers. These covenants typically relate to certain financial metrics or performance thresholds that the borrower must observe throughout the loan term. Examples of financial covenants include maintaining a debt-to-equity ratio below a specified limit or ensuring a minimum level of current ratio.

Financial covenants operate as safeguards for the lender, ensuring the borrower remains financially stable and capable of meeting repayment obligations. These covenants help monitor a borrower's financial health and can trigger remedial actions if the terms are violated. For example, imagine a loan agreement that specifies the borrower must maintain a minimum EBITDA threshold to ensure adequate cash flow; if the borrower's EBITDA falls below this level, they must negotiate with the lender or risk default.

Examples of financial covenants include requirements to maintain at least 1.5x fixed charge coverage ratio or limits on additional borrowing. Borrowers and lenders negotiate these covenants extensively, balancing protection for the lender and operational flexibility for the borrower.