Financial covenants are promises in a loan agreement to keep particular ratios within agreed limits. The most common are a leverage covenant, capping debt as a multiple of EBITDA, and an interest cover covenant, setting a minimum multiple of earnings over interest, often joined by a cash flow cover test. Every term is defined in the facility agreement itself, the ratios are tested at set intervals on figures the borrower supplies, and a breach is normally an event of default.

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What are financial covenants and where do you find them?

HMRC’s International Manual, which studies third party loan agreements closely because it uses them as the benchmark for thin capitalisation, calls the covenants section essential reading because it records the conditions of the debt in detail (INTM522010). It groups the usual financial covenants into three kinds:

  • profit and loss ratios, for example interest cover;
  • balance sheet ratios, for example gearing and liquidity;
  • cash flow ratios, for example cover for interest and loan repayments, along with restrictions on investments.

The numerical limits sit in the covenant clause, but the definitions of each ratio sit in the definitions section, and INTM522010 stresses that particular attention must be paid to those definitions. The agreement will also say how often, and in what form, financial information must be provided. The minimum events of default it identifies are non payment of interest or capital, insolvency and breach of covenant. Alongside the ratios there are usually other undertakings, such as limits on dividends and restrictions on asset sales.

Which covenants do lenders use most?

INTM516010 says loan covenants commonly include a maximum ratio of debt to earnings and a minimum ratio of earnings to interest costs. INTM519070 adds that the interest cover test often uses the EBITDA to interest ratio, the leverage test is often based on debt to EBITDA, and there may also be a cash flow covenant based on a ratio of cash flow to interest. HMRC’s own guidance on agreements says a set of covenants should normally have two ratios, one debt related and one governing interest (INTM520050).

The choice depends on the business. INTM517010 describes debt to EBITDA as common in third party lending for the general run of trading companies, while debt to equity ratios feature most in loan agreements for financial businesses such as motor finance or leasing companies, where money is almost their trading stock. Whatever the business, read the actual clause rather than assuming the usual pair.

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How is the leverage covenant calculated?

Leverage is debt divided by EBITDA for the test period, and the covenant sets a maximum. INTM515010 describes EBITDA, earnings before interest, tax, depreciation and amortisation, as a measure commonly used for covenants, reached by adding back the profit and loss charges for depreciation and amortisation to EBIT. INTM517010 notes that EBITDA stands as an approximation of cash flow and in practice may be fine tuned for non cash accounting entries or actual capital expenditure.

Both halves of the ratio are whatever the agreement says they are. Before calculating, check whether debt includes leases, overdrafts, guarantees and shareholder loans; whether cash is deducted to give a net figure; and which one off items may be added back to EBITDA. Our page on EBITDA covers the usual adjustments, and the gearing ratio covers the balance sheet alternative.

How are interest cover and cash flow cover calculated?

INTM516010 gives the basic interest cover calculation as earnings before interest and tax divided by interest payable, with the example of £12m EBIT against £3m interest giving cover of 4:1. It measures the ability to service debt, not to repay it. Many facilities use EBITDA rather than EBIT, and HMRC says an agreement should state how any interest receivable is treated (INTM520050). There is more detail on interest cover.

Cash flow cover goes further. INTM516080 describes adjusting EBITDA for items such as capital expenditure and tax paid to reach cash flow, then setting a covenant for cover of interest plus all debt repayments. It says that ratio should be greater than 1:1 because there will be other calls on cash flow, such as dividends. This is the same idea as the debt service cover ratio.

What does a covenant test look like in practice?

Illustration only. A company’s facility sets maximum net debt to EBITDA of 3.0 times and minimum EBITDA interest cover of 4.0 times. For the test period it reports operating profit of £1.1m, depreciation and amortisation of £0.4m, interest of £0.3m, borrowings of £4.5m and cash of £0.5m.

Test Calculation Result Limit Headroom on EBITDA
EBITDA £1.1m + £0.4m £1.5m
Net debt to EBITDA (£4.5m less £0.5m) / £1.5m 2.67 times 3.0 maximum EBITDA can fall to £1.33m, about 11%
Interest cover £1.5m / £0.3m 5.0 times 4.0 minimum EBITDA can fall to £1.2m, 20%

Both tests pass, but leverage is the one that binds first. If the definition of debt did not allow cash to be deducted, leverage would be exactly 3.0 times and the company would have no headroom at all. Working out how far EBITDA can fall before each test fails is more useful to directors than the ratios themselves.

How and when are covenants tested?

INTM516010 explains that covenants are applied to a borrower’s balance sheet or operating results at intervals to check that it is maintaining its ability to service and repay the borrowing, and that a breach will normally trigger close attention from the lender. The lender monitors compliance through the borrower providing the relevant financial information regularly (INTM519070). A well drafted agreement states explicitly how each ratio is calculated, which years the ratios apply to and the value for each period, and may attach a worked example where the calculations are complex (INTM520050).

Limits are not meant to be run close to. HMRC notes that covenants such as EBITDA interest cover should have headroom built in, because neither bank nor borrower expects the borrower to bump up against the limit, and setbacks such as a downturn should be absorbable without breach (INTM515060). It gives redundancy costs from a contraction of the business as an example of a normal expense that headroom should absorb.

What happens when accounting rules change?

Covenants are usually insulated from changes in accounting standards. The IASB’s effects analysis for IFRS 16 records that IFRS does not define terms such as debt and EBITDA, so they are defined independently in loan documents, and that covenants based on financial statement amounts are often based on the accounting in force when the facility was signed, known as frozen GAAP. HMRC’s guidance describes the same approach: computational adjustments reinstate the accounting position on which the covenants were based (INTM515070).

This is live for FRS 102 reporters now. The revised lease rules apply for accounting periods beginning on or after 1 January 2026 and bring most leases onto the balance sheet as a right of use asset and lease liability (FRS 102 paragraphs 1.37 and 20.45). ACCA’s factsheet on the change says an early impact assessment is strongly advisable where covenants are in place, as debt covenants could be breached, and that issues should be raised with lenders sooner rather than later. If the agreement does not freeze the accounting, recalculate the covenants on the new basis before the first test date.

What happens if a covenant is breached?

INTM520060 lists the likely consequences in third party lending: most often an increase in the cost of borrowing, sometimes a complete refinancing, a requirement for more security or support, a tightening of terms by other creditors and, ultimately, foreclosure on the loan or the appointment of receivers. It also observes that it is most unusual for an arm’s length lender to amend covenants retrospectively. INTM519070 notes that a breach is typically taken very seriously and that one possible remedy is an injection of more equity into the business.

A breach also has accounting consequences, because the loan may have to be shown as payable within one year. See breached loan covenant classification and going concern assessment.

What mistakes come up most often?

  • Using the EBITDA or debt figure from the statutory accounts instead of the defined figure in the facility agreement.
  • Forgetting that a change in accounting policy may move the ratio even though the agreement freezes the old basis, or the reverse.
  • Checking covenants only when the annual accounts are signed, rather than on each test date and on forecasts.
  • Reporting the ratio without the headroom, so the board does not see how close a breach is.
  • Assuming the bank will waive a breach after the event instead of raising it early.

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Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 19 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.