Covenant Stress (Canada): Warning Signs and Options Before a Default

By Brent Finlay, Business Finance Specialist (CPA,CMA MBA)
Originator of $150M+ in Loans & Leases for 100’s of Canadian SME’s | Creator of the BFE 5-Step Strategic Funding Process | Fractional CFO & Change Management Expert.
Published:  Feb 13, 2026.   Updated: Feb 16, 2026

Loan covenants can feel “invisible” until they suddenly matter.

Many Canadian SMEs don’t realize they’re under covenant stress until the bank starts asking for:

• more reporting
• updated financials sooner
• explanations for variances
• meetings “to review the file”
• tighter conditions or reduced flexibility

Covenant stress doesn’t automatically mean the business is failing. It often means the lender sees higher risk and wants clarity and control.

This page explains the common warning signs, what usually happens when covenants are breached, and practical options to stabilize things before it becomes a default scenario.

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What are covenants (in plain language)?

Covenants are rules in a loan agreement that require the business to maintain certain conditions.

They commonly fall into two categories:

1) Financial covenants

Examples (varies by lender):

• DSCR (debt service coverage)
• leverage ratios (debt-to-EBITDA)
• tangible net worth or equity minimums
• working capital ratios
• minimum EBITDA or cash flow thresholds

2) Reporting and behavior covenants

Examples:

• monthly/quarterly financial reporting deadlines
• notice requirements (material changes, litigation, tax arrears)
• restrictions on additional debt
• restrictions on owner draws/dividends
• restrictions on asset sales

Covenants are not “bad.” They’re a way lenders monitor risk and respond early.

The earliest warning signs of covenant stress

Covenant stress usually shows up before the covenant test date.

Common early signals include:

1) Increased reporting requests

• “Can you send month-end statements sooner?”
• “We need updated AR/AP aging.”
• “Please provide a 12-month forecast.”

2) “Relationship manager pressure”

• more frequent calls
• more questions about sales, margins, large customers
• “We need to take this to credit.”

3) Tightening on renewals or amendments

• delayed renewals
• increased pricing discussions
• requests for additional security or guarantees

4) Reduced tolerance for variance

A bank that previously accepted uneven months suddenly wants explanations for small dips.

5) Borrowing base / availability concerns

If you have a revolving line tied to assets, the lender may scrutinize:

• receivable aging
• concentration
• inventory quality

6) DSCR creep (you feel it operationally)

Even if you aren’t tracking DSCR, signs include:

• payments feel heavier relative to cash flow
• you rely more on the line to cover normal expenses
• cash balances trend down even when sales are stable

What happens if a covenant is breached (typical reality)

This varies by lender and severity, but generally:

1) The lender issues a notice (or requests a discussion first)

Sometimes it’s formal. Sometimes it’s “let’s meet.”

2) The lender asks for a remediation plan

They want to see:

• what changed
• whether it’s temporary or structural
• how management will stabilize results
• how reporting will improve

3) The lender may require an amendment or waiver

A waiver/amendment often comes with:

• higher interest rate or fees
• tighter reporting requirements
• restrictions on draws/dividends
• additional collateral or guarantees
• revised covenants or covenant resets

4) The lender increases monitoring

More frequent reporting, more scrutiny, and less tolerance for surprises.

5) If unmanaged: it can become an event of default

That’s the scenario you want to avoid—because decision-making shifts from flexibility to enforcement.

The key is to treat covenant stress early, before it becomes formal default territory.

The “before default” options (practical playbook)

Option 1: Get ahead of it with a proactive lender package

This is often the best first move.

Prepare:

• current interim statements
• AR/AP agings
• debt schedule
• 13-week cash flow forecast
• a 12-month forecast (if the issue is more than short-term timing)
• a short explanation of what changed and what you’re doing about it

Lenders respond better to clarity than surprises.

Option 2: Improve cash flow visibility and controls (fast wins)

• tighten AR collections and follow-up cadence
• reduce discretionary spending temporarily
• improve pricing/margin discipline where possible
• pause non-essential capex
• reduce owner draws while stabilizing

Even a small improvement in cash flow can change the tone of the conversation.

Option 3: Restructure debt to reduce payment stress (DSCR improvement)

If debt payments are too heavy:

• refinance to longer amortization
• consolidate stacked payments
• match repayment to asset life and cash cycle

This is where DSCR and covenant stress intersect.

(Internal link opportunity: your DSCR page.)

Option 4: Use the right working capital tool (if the issue is timing)

If the stress is driven by timing gaps:

• A/R financing
• inventory financing
• ABL structures (A/R + inventory)
• a cleaner LOC structure

(Internal links to Section 4 pages.)

Option 5: Negotiate covenant resets (when the story is credible)

If the business is viable but in a temporary dip, lenders sometimes consider:

• covenant relief periods
• revised covenants aligned to a realistic forecast
• stepped covenant thresholds over time

This usually requires good reporting and a believable plan.

Option 6: Create a parallel plan (if lender confidence is weakening)

If you sense the bank is losing comfort:

• explore refinance options early
• build an alternative lender path
• plan for timing and documentation

Waiting until the lender enforces typically reduces options.

The most important mindset shift

Covenant stress is not just a “bank problem.” It’s an early warning system.

If you treat it as:

• a reporting/communication problem, and
• a cash flow / structure problem,
  …you can often stabilize it before it escalates.

If you treat it as “ignore it and hope,” it usually gets worse.

Frequently Asked Questions

What is covenant stress in business lending?

Covenant stress is when a business is at risk of breaching loan covenants or already approaching covenant thresholds. It often shows up as increased lender reporting requests, tighter renewals, and reduced tolerance for financial variance.

Does a covenant breach mean the bank will call the loan?

Not always. Many lenders prefer to work through a waiver or amendment if the business is viable and management is proactive. However, unmanaged covenant breaches can escalate and reduce options.

What should I do first if I think I might breach covenants?

Get clarity fast: prepare updated financials, AR/AP agings, a debt schedule, and a short-term cash flow forecast. Then proactively communicate a realistic plan to the lender before the test date or before the lender loses confidence.

Can refinancing help with covenant stress?

Often, yes. If the issue is payment burden or structural mismatch, refinancing to reduce payments or extend amortization can improve DSCR and reduce covenant pressure—assuming lender fit and documentation are strong.

Why do lenders increase reporting when a file is under stress?

Increased reporting reduces uncertainty. Lenders want early visibility into cash flow, collections, margins, and risks so they can decide whether the situation is temporary or structural.

Can a fractional CFO help with covenant stress?

Yes. Fractional CFO support often improves the reporting cadence, cash flow forecasting, and lender communication that helps stabilize covenant situations before they escalate.

Related Answers

What Is a Fractional CFO? (Services, Cost, and When It Makes Sense)
What they do, what they don’t, and when it’s worth it.

What Lenders Want to See in a Cash Flow Forecast (Canada)
Forecast requirements that improve lender confidence and reduce conditions.

DSCR (Debt Service Coverage Ratio): What It Is, Why It Matters, and How to Improve It (Canada)
How lenders calculate coverage...and practical levers to raise it.

Need help managing covenant stress?

Most people contact me when they have a pressing financing issue and don’t know where to start—or they’re stuck mid-process, have been declined, or need a clear next step. If you want experienced help clarifying options, strengthening reporting and forecasts, and building a practical path forward before things escalate, reach out.

**Three ways to move forward:**

1. Access my free 5 Step Strategic Funding Process through this link 
2. Email your situation through my contact form
3. Book a 15-minute discovery call through this calendar link

Or call: 905-690-9874

Business Finance Specialist