Covenant
Compliance
Checker
Test up to 6 financial covenants, calculate headroom or breach deficit, and generate an ISA 570 going concern working paper — ready for your engagement file.
A financial covenant breach occurs when a borrower's ratio falls outside the contractually agreed threshold. Under ISA 570.A3, a covenant breach is a going concern indicator. Under IAS 1.74, an unwaived breach requires the debt to be reclassified as current.
Why covenant compliance matters for auditors
Financial covenants are contractual tests embedded in loan agreements, revolving credit facilities, and bond indentures that require borrowers to maintain certain financial ratios within agreed thresholds. Common covenants include Net Debt/EBITDA (leverage), interest coverage, debt-to-equity, current ratio, and solvency ratio. Covenant testing typically occurs quarterly or annually, using financial data from management accounts or audited financial statements.
For auditors, covenant compliance has direct implications under multiple ISAs and IFRS standards. Under ISA 570.A3, a covenant breach or near-breach is listed as a financial indicator of potential going concern risk. The auditor is required to obtain sufficient appropriate audit evidence to conclude whether management's use of the going concern basis is appropriate — and a covenant breach is one of the clearest triggers for a full ISA 570 assessment.
Under IAS 1.74, if a long-term borrowing covenant is breached at or before the reporting date and has not been waived by the lender before the financial statements are authorised for issue, the entire borrowing must be reclassified as a current liability. This reclassification can dramatically change the current ratio and net current liability position — transforming an entity that appeared financially stable into one with a net current liability deficit. The resulting disclosure requirements under IAS 1.75 and IFRS 7.B10A require specific disclosures about the breach, the carrying amount of the affected debt, and the lender's response.
Common financial covenant types
The most frequently encountered financial covenants in European bank lending include:
- Net Debt/EBITDA — tests leverage; must not exceed a specified multiple (typically 2.5x–4.0x). The exact definitions of "Net Debt" and "EBITDA" are specified in the loan agreement and often differ from accounting figures.
- Interest Coverage Ratio — EBIT divided by interest expense; measures debt serviceability. Must exceed a minimum (typically 2.5x–3.5x).
- Debt-to-Equity Ratio — limits total borrowing relative to shareholders' equity. Common in real estate and capital-intensive industries.
- Current Ratio — current assets divided by current liabilities; tests short-term liquidity. Often used in revolving credit facilities and supply chain finance.
- Solvency Ratio — total equity as a percentage of total assets; measures capital adequacy. Used extensively in Dutch and Belgian bank lending (Dutch: "solvabiliteit").
- DSCR — Debt Service Coverage Ratio: EBITDA divided by total debt service (interest plus principal repayments). Common in project finance and property lending.
Covenant definitions in loan agreements vs accounting definitions
One of the most common audit findings in covenant testing is the use of accounting-derived figures where the loan agreement specifies a different definition. EBITDA in a loan agreement typically includes adjustments for exceptional items, non-cash charges, and restructuring costs that are excluded from the accounting definition. Net Debt may exclude certain ring-fenced cash balances or include off-balance-sheet exposures not captured in IFRS 16 lease liabilities. "Total Debt" may be defined to include or exclude shareholder loans.
Auditors testing covenant compliance must:
- Obtain the original loan agreement and any amendments, waivers, or consent letters
- Read the definitions section carefully and identify any differences from accounting definitions
- Recalculate all covenant metrics using the contractually defined inputs
- Obtain management's covenant compliance certificate or compliance pack and compare to independent calculation
- If a breach is identified, determine whether it was waived before year-end and obtain written confirmation from the lender
Frequently asked questions
Why do financial covenants matter for the audit?
Covenant breaches are a significant going concern indicator under ISA 570.A3. When a borrower breaches a financial covenant, the lender may have the right to demand immediate repayment. If the breach is not waived before the financial statements are authorised for issue, IAS 1.74 requires the related borrowing to be reclassified as a current liability — potentially triggering a net current liability position and going concern risk. Auditors are required to perform procedures to identify covenant breaches and assess their implications for the audit opinion.
How is Net Debt/EBITDA calculated and what is a typical threshold?
Net Debt/EBITDA = (Total debt − cash and cash equivalents) / EBITDA. The result shows how many years of earnings (before interest, taxes, depreciation and amortisation) would be required to repay net debt. Common covenant thresholds range from 2.5x to 4.0x depending on industry and credit rating. Investment-grade companies typically target below 2.5x. A threshold of 3.0x means the entity's net debt must not exceed three times its annual EBITDA. The exact definition of EBITDA in the loan agreement often differs from the accounting figure — auditors must use the contractually defined metric.
What happens when a covenant is breached?
When a financial covenant is breached: (1) the lender typically has the right to accelerate repayment of the loan; (2) under IAS 1.74, the debt must be reclassified as current if the breach is not waived before the financial statements are authorised; (3) cross-default clauses in other debt instruments may be triggered; (4) the breach is a going concern indicator under ISA 570.A3 — the auditor must assess whether there is substantial doubt about going concern; (5) IFRS 7.B10A requires disclosure of defaults on principal, interest, or covenant terms. The auditor should obtain evidence of any waiver agreed before the reporting date.
What is the interest coverage ratio and how is it used in covenants?
The interest coverage ratio (ICR) = EBIT / Interest expense. It measures how many times the entity can cover its interest payments from operating earnings. Common covenant thresholds require ICR ≥ 2.5x or ≥ 3.0x. A ratio below 1.0x means interest payments exceed operating earnings — a strong going concern indicator. The exact definitions of EBIT and interest in the loan agreement should be used, as 'adjusted EBIT' (excluding exceptional items) is common. The ICR is closely watched by lenders as a measure of debt serviceability and is typically tested quarterly for leveraged transactions.
What disclosures are required for covenants under IAS 1 and IFRS 7?
IAS 1.136 requires disclosure for each class of borrowings: the terms and conditions, including covenant requirements. IAS 1.74 requires that if the entity has breached a covenant on a long-term borrowing and the breach has not been waived before the balance sheet date, the liability is classified as current. IAS 1.75 requires disclosure of: the nature of the covenant breach, the carrying amount of the related borrowing, and whether the lender has agreed to waive the covenant. IFRS 7.B10A requires disclosure of any defaults on principal, interest, sinking fund, or redemption provisions during the period, and the carrying amount of borrowings in default.