Interest cover

Q: What does a covenant test look like in practice?

Illustration only. A company has a facility requiring EBITDA to be at least four times interest payable, tested on the last twelve months each quarter. Item£ Operating profit (EBIT)300,000 Add back depreciation and amortisation100,000 EBITDA400,000 Interest payable80,000 Interest cover on EBITDA5.0 times Interest cover on EBIT3.75 times The covenant is met with headroom: EBITDA could fall to £320,000 (4 × £80,000), a drop of £80,000 or 20%, before breach. If rates rise and interest goes to £95,000, the minimum EBITDA becomes £380,000 and the headroom shrinks to 5%, without any change in trading.

Interest cover is operating profit divided by interest payable, and shows how many times a business’s profits could pay its interest bill. ACCA’s ratio guidance treats anything above three as usually safe, but lenders set their own minimum in loan covenants and define every term in the facility agreement, so the ratio that counts is the one calculated the lender’s way.

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How is interest cover calculated?

ACCA’s ratio analysis article gives the formula as operating profit divided by finance costs, and notes it is sometimes called income gearing. HMRC’s International Manual at INTM516010 puts it the same way: earnings before interest and tax (EBIT) divided by interest payable. HMRC’s own example is profit before interest and tax of £12m against interest payable of £3m, giving cover of 4:1.

The result is a multiple, not a percentage. Cover of 4 means profits would have to fall by three quarters before they no longer met the interest charge. INTM516010 stresses that the ratio measures the ability to service debt, that is to pay interest and the regular costs of borrowing, not the ability to repay the principal.

Which profit and interest figures should you use?

The starting point is the operating profit line, explained in our guide to gross, operating and net profit. Three choices then change the answer.

EBIT or EBITDA

Many lenders use earnings before interest, tax, depreciation and amortisation. INTM515010 describes EBITDA as a measure commonly used in third party lending covenants because it is closer to cash flow. INTM515030 warns that adding back depreciation removes any provision for replacing assets, so cover can look better than it is if heavy capital expenditure is due.

Gross or net interest

INTM516020 says the starting point is the interest payable shown in the profit and loss account, and that interest payable and receivable should not automatically be netted. INTM516040 shows why: operating profit of £20.1m against interest payable of £7.6m gives cover of 2.6, but netting £2.4m of interest receivable lifts it to 3.9.

Accounting charge or cash interest

INTM516020 also notes that the finance cost in the accounts may differ from cash interest, because discounts, redemption premiums and other costs are spread over the life of a loan. A covenant definition will say which figure is used.

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What level of interest cover is acceptable?

ACCA’s article says the higher the figure, the more likely a company can meet its interest payments, and anything over three is usually considered safe. That is a rule of thumb, not a standard. HMRC’s guidance at INTM516050 says interest cover levels agreed with third party lenders vary considerably between types of business, that lenders may accept lower cover for several years after an acquisition, and that good security over property can make lenders more relaxed about cover. A property investor with long leases can run lower cover than a contractor whose profits swing year to year.

How do interest cover covenants work in a loan agreement?

INTM516010 describes covenants as promises applied to a borrower’s balance sheet or results at intervals to check it can still service and repay the borrowing. Loan covenants commonly include a maximum ratio of debt to earnings and a minimum ratio of earnings to interest; the second is interest cover. A breach will normally trigger close attention from the lender.

INTM522010, on the general form of third party debt agreements, lists the usual financial covenants as profit and loss ratios such as interest cover, balance sheet ratios such as gearing and liquidity, and cash flow ratios such as cover for interest and loan repayments. It advises reading the definitions section closely, because that is where the way each ratio is measured is set out, and notes that agreements may tie the interest margin to improving or declining covenant ratios, limit dividends and set what financial information must be supplied and when.

The practical points for a borrower are:

calculate the ratio exactly as defined, including any agreed add backs or exclusions;
check the test period, often a rolling twelve months, and the test dates;
monitor headroom in the management accounts rather than waiting for the year end accounts;
remember that a breach of any other covenant, such as gearing, can be just as serious.

What does a covenant test look like in practice?

Illustration only. A company has a facility requiring EBITDA to be at least four times interest payable, tested on the last twelve months each quarter.

Item	£
Operating profit (EBIT)	300,000
Add back depreciation and amortisation	100,000
EBITDA	400,000
Interest payable	80,000
Interest cover on EBITDA	5.0 times
Interest cover on EBIT	3.75 times

The covenant is met with headroom: EBITDA could fall to £320,000 (4 × £80,000), a drop of £80,000 or 20%, before breach. If rates rise and interest goes to £95,000, the minimum EBITDA becomes £380,000 and the headroom shrinks to 5%, without any change in trading.

What happens if an interest cover covenant is breached?

INTM515010 says that if a borrower fails a covenant test the lender may take action to protect its investment. Depending on the agreement, that can mean a waiver fee, a higher margin, extra security or, at worst, the loan becoming repayable on demand.

There are also accounting consequences. Where a loan is in breach or default at the reporting date and this has not been remedied, FRS 102 paragraph 11.47 requires disclosure of the details, the carrying amount of the loan and whether the breach was remedied or the terms renegotiated before the accounts were authorised for issue. Small entities using Section 1A have fewer mandatory disclosures, but paragraph 1A.16 still requires enough information in the notes to give a true and fair view. A breach also feeds directly into the directors’ going concern assessment.

How do the 2026 lease accounting changes affect interest cover?

For accounting periods beginning on or after 1 January 2026, FRS 102 (September 2024) brings most leases onto the lessee’s balance sheet. ACCA’s factsheet on lease accounting under FRS 102 explains that the right of use asset is depreciated and the lease liability carries a finance cost, replacing the old operating lease rental charge. Rent therefore moves partly into interest, and EBITDA rises.

ACCA advises an early impact assessment where loan covenants exist, because bringing leases onto the balance sheet may mean covenants are breached, and recommends raising issues with lenders sooner rather than later. Check whether your facility tests covenants under the accounting standards in force when it was signed or under the standards as they change. See FRS 102 2026 amendments.

Is interest cover the same as the corporate interest restriction?

No. Interest cover is a credit measure agreed with lenders. The corporate interest restriction is a tax rule that, according to HMRC’s guidance, only applies to companies or groups with net interest and financing costs over £2 million in a 12 month period. Under its fixed ratio method the allowance is broadly the lower of 30% of UK taxable profits before interest, taxes, capital allowances and some other reliefs, and the worldwide net interest expense.

Interest cover does appear in tax in one place: HMRC’s thin capitalisation guidance uses interest cover covenants in Advance Thin Capitalisation Agreements, and INTM516010 explains that if the covenant is breached enough interest is disallowed to restore the ratio.

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Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 8 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.