What counts as capital expenditure in a loan covenant?

Whatever the facility agreement's definition says. Most definitions start from the accounts, counting spending recorded as additions to property, plant and equipment and often to intangible assets such as capitalised software. They then add or remove items by name: assets acquired on finance lease, the purchase of a business, and spending paid for with new equity, reinvested sale proceeds or insurance money. Two agreements with the same cap can permit very different spending because of the definition.

What is the difference between carry-forward and carry-back in a capex covenant?

A carry-forward moves unspent allowance from one year into the next, so a quiet year leaves extra room for the following one. A carry-back works the other way: the borrower spends part of next year's allowance now, and next year's allowance is reduced by the same amount. Carry-forward rewards restraint; carry-back accommodates timing. Agreements often cap both, and may limit each to one year either side.

What happens if a borrower exceeds its capex limit?

It has broken an undertaking, which is usually an event of default. Where the cap is written as a financial covenant the default is immediate; where it is a general undertaking, a grace period for breaches capable of remedy may apply, though money already spent is hard to remedy. In practice the borrower asks for consent before spending, and the lender either agrees, agrees with conditions such as equity funding or a lower dividend, or declines. A breach found only when the annual certificate is delivered is harder to resolve, because the money has gone.

Why limit capex when the lender already tests leverage?

Because leverage reports after the event. A business can commit cash to a large project in one quarter and show no change in its ratios until the spending is complete and the expected earnings have or have not arrived. A capex limit gives the lender a conversation before the commitment is made. Where a loan is to be repaid from cash flow over a short period, that timing can matter more than any ratio.

// WORKED EXAMPLETHE ARITHMETIC A DECISION RESTS ON

Capex Covenant: a Worked Example

A cap on spending, kept as a ledger that runs across the years.

BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED 2026-11-07

// THE SHORT ANSWER

Of all the ways a business can use its cash, capital spending is the one management can commit to furthest ahead, and the one a lender sees last in the ratios. A capex covenant gives the lender a say over it before the money is spent, by setting a yearly allowance. Most of the drafting is about how that allowance moves: what unspent room may roll into the following year, what may be borrowed from it, and which pot is used first. The covenant protects the lender's repayment. The lender's own risk is setting the allowance below what the assets need to keep working.

BASIS Practitioner judgment from sixteen years in commercial banking, set out in How Bankers Think (Highbank Press, 2026). Every borrower on this site is a composite constructed for teaching, not a client. The market is mid-market commercial lending as practised in New Zealand and Australia; where a convention differs elsewhere, the page says so.

// MAKE THE CALL

Issue 04 — Highview Industries. Same request as Issue 01 on the surface. A completely different file underneath. Your call first, then the senior banker's.

Read the file →

// 01 — WHY A LENDER LIMITS CAPITAL SPENDING

A lender sizes a term loan on the cash the business is expected to produce after keeping its assets in working order. Spending beyond that, on a new site, a second production line or a fleet that doubles the routes, uses cash the lender counted on for repayment, and it is committed months before it shows in any ratio. Leverage and debt service cover report after the money has gone; a capex covenant acts before it goes.

Depending on the document, the covenant sits among the general undertakings or among the financial covenants. Either way the borrower promises not to spend more than the permitted amount in a financial year without consent, and reports compliance with the annual accounts through the compliance certificate. A lender may instead require consent for any single project above a stated sum, or use both. Nothing in New Zealand, Australian or UK law prescribes either; both are terms of the contract.

// 02 — HOW THE ALLOWANCE IS CALCULATED

Permitted capex, year n = base amount for year n

+ amount carried forward from year n−1

+ amount carried back from year n+1

Base for year n+1 = its scheduled base − amount carried back into year n

Four drafting choices decide what the formula produces. The first is the definition of capital expenditure. It is usually tied to the accounts, so that additions to property, plant and equipment count, and the document says whether assets taken on finance lease, capitalised software and acquisitions are inside or outside it. The second is what is excluded: spending funded by new equity, by reinvested sale proceeds or by insurance money after a loss is commonly left out, because none of it uses the cash the lender is relying on.

The third is how much may move between years. A carry-forward may be the whole unspent amount or a capped part of it, and is often usable in the next year only. A carry-back lets a borrower use part of next year's base now, and next year's base falls by the same amount. The fourth is the order of use: whether the carried-forward amount is treated as spent before the current year's base or after it. That choice looks clerical and is not, as the example shows.

// 03 — THE EXAMPLE

A commercial bakery, constructed for this page, has a term loan whose capex covenant sets a base of US$4.0m a year. Unspent room may roll into the following year only, up to US$2.0m, and a carried-forward amount is treated as spent first. Up to US$1.0m may be carried back from the following year. All of these levels are the example's, not a market norm. The bakery's own estimate of what its plant needs each year simply to keep running is US$3.0m.

Year 1 allowance 4.0 spent 2.6 unused 1.4 → carried forward 1.4

Year 2 allowance 4.0 + 1.4 = 5.4 spent 6.0 (with oven line) short 0.6 → carried back from Year 3

used: carried 1.4 first, then base 4.0, then carry-back 0.6 = 6.0

Year 3 allowance 4.0 − 0.6 = 3.4 maintenance need 3.0 room 0.4

The new line fits inside the covenant, but it leaves Year 3 with US$0.4m above what the bakery expects simply to keep running. If a delivery van fleet worth US$1.5m, outside that plant estimate, comes due for replacement in that year, even the full carry-back from Year 4 leaves it short: 3.4 + 1.0 = 4.4 of room against 3.0 + 1.5 = 4.5 of need, and borrowing from Year 4 only moves the squeeze a year on. The bakery will need the lender's consent, and the lender will be asked whether replacing the vans is the kind of spending the cap was meant to stop.

The order-of-use rule matters in a year that does not use all its room. Suppose instead the bakery spent US$4.5m in Year 2:

Carried amount used first: 1.4 carried + 3.1 base → 0.9 of base unused, carries to Year 3

Base used first: 4.0 base + 0.5 carried → 0.9 of old carry expires, nothing carries

The spending is identical. Under the first rule the bakery starts Year 3 with US$4.9m of room; under the second, with US$4.0m. A borrower negotiates for the first; a lender that wants old room to expire asks for the second.

// 04 — WHAT A LENDER READS BESIDE IT

The allowance means little until it is set against maintenance capex, the spending needed to hold the business's capacity where it is. A cap close to that level leaves no room for growth, which may be the lender's intention for a business that is paying down debt. A cap below it is a different matter: the business can comply only by deferring replacements, and the cost arrives later as breakdowns, higher repairs and lost output.

A lender therefore reads capex against depreciation over several years, the age of the main assets, and the repairs line. It also reads the cover ratios that deduct capex, because debt service cover measured after capital spending shows the cash the covenant was protecting.

DEFINED IN ONE PARAGRAPH → · LOAN COVENANTS, EXPLAINED → · PRODUCT FILE: TERM LOAN →

// 05 — WHERE IT DECIDES A FILE

The base is set at the term sheet against the borrower's plan, and the plan is where the argument happens. A lender asks which projects the plan contains, which are needed to keep the business running and which are bets on growth, how each will be paid for, and how the timing could slip. A lumpy plan, with one large project in an otherwise quiet run of years, is the case for a carry-back; a plan that spends the same every year needs little movement between them.

During the loan, the covenant turns most large projects into a consent request. That request is a small credit decision: what the project earns, how long it takes to pay back, what it does to cover in the year it is built, and whether equity should fund part of it so that it falls outside the cap. A borrower that brings that analysis with the request is answered faster than one that brings an invoice.

HOW BANKS TEST FORECASTS → · HOW BANKS READ MANUFACTURING →

// QUESTIONS PEOPLE ASK

What counts as capital expenditure in a loan covenant?: Whatever the facility agreement's definition says. Most definitions start from the accounts, counting spending recorded as additions to property, plant and equipment and often to intangible assets such as capitalised software. They then add or remove items by name: assets acquired on finance lease, the purchase of a business, and spending paid for with new equity, reinvested sale proceeds or insurance money. Two agreements with the same cap can permit very different spending because of the definition.
What is the difference between carry-forward and carry-back in a capex covenant?: A carry-forward moves unspent allowance from one year into the next, so a quiet year leaves extra room for the following one. A carry-back works the other way: the borrower spends part of next year's allowance now, and next year's allowance is reduced by the same amount. Carry-forward rewards restraint; carry-back accommodates timing. Agreements often cap both, and may limit each to one year either side.
What happens if a borrower exceeds its capex limit?: It has broken an undertaking, which is usually an event of default. Where the cap is written as a financial covenant the default is immediate; where it is a general undertaking, a grace period for breaches capable of remedy may apply, though money already spent is hard to remedy. In practice the borrower asks for consent before spending, and the lender either agrees, agrees with conditions such as equity funding or a lower dividend, or declines. A breach found only when the annual certificate is delivered is harder to resolve, because the money has gone.
Why limit capex when the lender already tests leverage?: Because leverage reports after the event. A business can commit cash to a large project in one quarter and show no change in its ratios until the spending is complete and the expected earnings have or have not arrived. A capex limit gives the lender a conversation before the commitment is made. Where a loan is to be repaid from cash flow over a short period, that timing can matter more than any ratio.

THE IN-TRAY · ONE MINUTE

Make the call on one file.

A short file on the ground this page covers. Every option opens with how far it sits from a senior banker’s read.

THE FIRST QUESTION · THE LOAN · PROTECTION

A bank lends to a holding company whose only assets are shares in three operating subsidiaries. The subsidiaries have their own bank debt and trade creditors.