When an MSME owner gets a sanction letter, the first instinct is relief “Loan approved!”. But buried inside that document are conditions that can trigger default, even if you never miss an EMI. These hidden promises are called loan covenants. In this article, let’s understand in detail what covenants are, why banks insist on them, the silent traps borrowers overlook, and the checklist you must follow to stay safe.
What Are Loan Covenants?
Covenants are promises written into your loan agreement. They go beyond repayment they set rules for how you must run your business and finances during the loan period. There are two main types:
- Positive covenants – actions you must take (e.g., maintain insurance, submit stock statements).
- Negative covenants – restrictions on what you cannot do (e.g., take new loans without approval, change ownership structure).
For banks, covenants are safety nets. For borrowers, they can sometimes feel like handcuffs if not fully understood.
Common Loan Covenants
- Financial Covenants
- Maintain minimum ratios like DSCR ≥ 1.25 or Current Ratio ≥ 1.33.
- Breach = violation, even if EMIs are paid.
- Information Covenants
- Submit audited financials, GST returns, stock & receivable statements on time.
- Miss deadlines → technical default.
- Restrictive Covenants
- No additional borrowing without bank consent.
- No excessive dividend payouts.
- No changes in ownership/promoters.
- Collateral Covenants
- Mandatory insurance with the bank as beneficiary.
- Maintain margins in stock/receivables for working capital.
The Silent Traps Borrowers Miss
- Technical Default – You can be in default without missing EMI. Late submission of stock statements, audit reports, or ratio breaches can trigger this.
- Cross-Default Clause – If you default elsewhere, even with another lender, your current loan can also be treated as default.
- “As and When Required” Clauses – Bank reserves right to demand more collateral later.
- Dividend Restrictions – Promoters may not be free to withdraw profits.
Example: An MSME client once had their working capital limit frozen because they missed quarterly stock audit submission even though repayment was on time.
Why Banks Use Covenants
Banks don’t insert covenants to “trap” borrowers. They do it to:
- Protect depositors’ money.
- Monitor borrower health proactively.
- Ensure transparency and discipline.
Think of them as seatbelts — uncomfortable at times, but meant to protect.
Borrower’s Checklist to Stay Safe
- Read sanction letter line by line.
- Create a compliance calendar (deadlines for stock statements, audits, insurance renewals).
- Negotiate unrealistic covenants upfront.
- Get clarifications in writing, not verbally.
- Communicate transparently with your banker if you foresee a breach.
Final Thought
Loan covenants are the silent traps inside your agreement. Break them — knowingly or unknowingly — and your banker has the right to recall the loan.
A smart borrower doesn’t just look at EMI and interest rate. They master the fine print.
Share this article with a fellow entrepreneur — it could save them from an unexpected default.
Want to go deeper? Listen to the full discussion on Smart Credit Bytes – Episode 10 on
🎧 Listen now on spotify: https://open.spotify.com/episode/6ggEj7ovqudpSFywt8dYiW?si=JOTVCx5oS26HcXIXy1Z3TA
🎧 Listen now on youtube: https://youtu.be/RAZ9QsZMIE4?si=tMKCIxMrEG6D_rZs
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