Your Credit Covenants Were Written When Margins Were Different

A founder I work with has a $6M revolving credit facility with a regional bank. The covenant requires minimum debt service coverage of 1.25x, tested quarterly. When he signed it 18 months ago, his coverage was 1.8x. Comfortable.

By Q4 2025, input costs were up 11% on his two largest product lines. Q1 2026 brought another round of tariff-driven increases. His Q1 EBITDA came in 22% below plan.

He didn't know his covenant was at risk until his banker called about the quarterly test.

What covenants actually measure

Most commercial credit facilities for companies in the $3M-$15M range include a debt service coverage ratio covenant. The threshold is typically 1.20x to 1.35x. The formula: operating cash flow divided by total debt service over the trailing twelve months.

What moves DSCR isn't revenue alone. It's the gap between revenue and cash left to service debt after operating expenses. Gross margin compression runs straight through to the numerator.

A company with $4M in revenue, $800K in EBITDA, and $500K in annual debt service has a 1.6x DSCR. If input costs compress gross margin by 5 points, EBITDA drops to roughly $600K. Coverage is now 1.2x. One more bad quarter puts them at or below covenant.

This math exists in a lot of credit agreements signed when margins were healthier.

The timing lag

The credit effect of tariffs and input cost inflation typically runs one to two quarters behind the actual cost hit. Costs hit your P&L in Q4 2025 and Q1 2026. Trailing-twelve-month DSCR calculations start fully reflecting those quarters now. Q2 2026 covenant tests will be the first complete read on what the cost environment has done to coverage ratios.

Most founders find out they're at risk when their banker calls. That call doesn't go the same direction if you've already reached out.

A proactive waiver conversation costs nothing and takes a few days. A covenant breach notification is a different relationship dynamic entirely.

Pull your credit agreement. Find the DSCR threshold. Calculate your current coverage on a trailing twelve-month basis through Q1. If you're at 1.4x or above, you're fine. Below 1.3x, the Q2 test is worth modeling carefully.

Before Q2

Banks grant covenant waivers routinely for borrowers who show up with a coherent plan. Rising input costs and tariff exposure are conditions your banker is aware of across their entire portfolio right now. A conversation in April is a planning discussion. A breach in June is a credit event.

An 18-month-old credit agreement almost certainly has thresholds that didn't anticipate the cost environment of early 2026. That's not a problem to hide. Bring it to your relationship banker with your operating plan attached.

Run the DSCR calculation today. If you're comfortable, you're done. If you're not, April is the right time to call.