What is included in net debt for covenant purposes?

Whatever the facility agreement's definition includes. Loans, overdrafts, bonds and finance leases are usually in. Guarantees of other parties' debt, deferred purchase price, hedging close-out amounts and receivables finance with recourse are often negotiated. Subordinated shareholder loans and ordinary trade credit are usually out. The cash deducted is normally limited to unrestricted cash the group can use, and may be capped. The only reliable answer for a given borrower is the definition in its own agreement.

Are lease liabilities included in net debt?

In the accounts, most leases are now liabilities: IFRS 16 has applied since 2019, and UK FRS 102 brings a similar model for periods beginning on or after 1 January 2026. In a covenant, it depends on the agreement. Many freeze the accounting basis at signing, counting only leases that were finance leases under the earlier rules and measuring EBITDA after rent. Others adopt the new basis and adjust the covenant level to match. The definition says which.

Is an earn-out counted as debt in a leverage covenant?

It depends on the wording. Some agreements count deferred purchase price as borrowing once it is fixed and payable, some count earn-outs only when they have been earned, and some exclude contingent consideration altogether. A lender's concern is that the payment will compete with debt service when it falls due, so it reads the earn-out's likely amount and timing whatever the covenant counts.

Why does net debt in the compliance certificate differ from the annual report?

Because they are built to different rules. The annual report's figure, where there is one, follows the current accounts: a management measure under IFRS, or the standard's own definition in UK accounts under FRS 102. The certificate's figure follows the facility agreement, which may freeze an older accounting basis, exclude restricted or capped cash, and add items such as guarantees. The certificate should reconcile the two so the lender can see each difference.

// WORKED EXAMPLETHE ARITHMETIC A DECISION RESTS ON

Net Debt Covenant Definition: a Worked Example

The ratio is only as tight as the list of what counts.

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

// THE SHORT ANSWER

Two borrowers with identical balance sheets can report different leverage, because the net debt a covenant tests is whatever their facility agreements say it is. The negotiation is over a list: which obligations are added as borrowings, which are left out, and which cash may be taken off. Leases, guarantees, deferred purchase price, hedging, shareholder loans and overdrafts each move the result. A lender reading a compliance certificate therefore reads the definition before the number, because the same accounts can pass the covenant or breach it depending on the words.

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.

// WORK THE SUM

Every Groundwork file that is a number to work out — cash conversion, debt service cover, expected loss, risk-weighted assets, the margin on a bank's own book — with the working shown in the senior read. One minute each, no signup.

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// 01 — WHY THE DOCUMENT WRITES ITS OWN NET DEBT

Accounting standards do not give a covenant a net debt figure it can simply adopt. IFRS, as applied in New Zealand, Australia and the UK, does not define net debt, so a company that reports one under it is using its own measure, chosen by management. UK FRS 102 does define it, as borrowings, related derivatives and lease obligations less cash and cash equivalents, and requires an analysis of its movement from entities that prepare a cash flow statement; but that is the accounts' definition, written without the lenders. A covenant needs a figure that the parties agree in advance, can calculate the same way every quarter, and cannot be changed by an accounting decision taken later.

So the facility agreement defines it, usually through a chain of defined terms: a definition of borrowings or financial indebtedness, a definition of cash and cash equivalents, and a net debt that is the first less the second. Every item in that chain is a choice. A lender wants the covenant to see every obligation that competes with the bank for the business's cash. A borrower wants room to run the business without each new arrangement counting against the ratio.

// 02 — WHAT THE DEFINITION ADDS AND TAKES AWAY

Net debt = borrowings as defined − cash the definition allows

Usually in: loans, overdrafts, bonds and notes, finance leases

Often argued: guarantees of others' debt, deferred purchase price,

hedging close-out amounts, recourse receivables finance

Often out: subordinated shareholder loans, trade credit on normal terms

Cash: unrestricted, held by the group or the guarantors, sometimes capped

Leases need care. For businesses applying IFRS 16, adopted in New Zealand and Australia through their equivalent standards, most leases have been on the balance sheet since 2019; UK companies reporting under FRS 102 follow a similar model for periods beginning on or after 1 January 2026. Facility agreements often freeze the accounting basis, so the covenant may count only the leases that would have been finance leases under the old rules. Overdrafts need care too: accounting standards allow an overdraft repayable on demand that is part of day-to-day cash management to be counted within cash and cash equivalents in the cash flow statement, so a certificate that takes cash from the accounts and also counts the overdraft as borrowing has counted it twice. The cash netting cap is the clause that limits the second half of the formula.

// 03 — THE EXAMPLE

An engineering group, constructed for this page like every figure in it, has a term loan of US$38m, US$6m drawn on a revolving facility, a US$3m overdraft and US$2m of leases that the covenant's frozen accounting basis counts. It also owes US$4m of deferred purchase price for a business it bought, has guaranteed US$3m of a joint venture's bank debt, and owes its shareholders US$5m under a subordinated loan. It holds US$9m of cash, of which US$2m is cover for bank guarantees. EBITDA on the covenant basis is US$14m.

Borrower's draft: (38 + 6 + 3 + 2) − 9 = 40 → 40 ÷ 14 = 2.86×

Lender's draft: (49 + 4 + 3) − (9 − 2) = 49 → 49 ÷ 14 = 3.50×

Shareholder loan in: (56 + 5) − 7 = 54 → 54 ÷ 14 = 3.86×

The business is the same on every line. The borrower's draft counts only bank debt and leases and takes off all the cash. The lender's draft adds the purchase price still owed and the guarantee, and takes off only cash the group can spend. The third line shows what including the shareholder loan would do, and why subordinated shareholder debt is usually left out: it ranks behind the bank and is commonly not paid while the bank is owed. A covenant set at, say, 3.25 times, the example's level and not a norm, passes on the first draft and fails on the second.

// 04 — HOW IT DIFFERS FROM THE ANNUAL REPORT'S NET DEBT

Where a borrower's annual report gives a net debt figure, it is a management measure under IFRS, or FRS 102's own definition in UK accounts, and either way it follows the current accounts: lease liabilities in, all cash off. The covenant figure follows the agreement, which may be frozen at an older accounting basis, exclude some cash and add items the accounts carry elsewhere. Neither is wrong. They answer different questions, and a reader who sees a reported net debt and a covenant net debt that differ is seeing the definition at work.

A credit paper may carry a third figure, the lender's own reading of everything with a claim on the business's cash, set out under debt-like items. The compliance certificate is where the covenant figure is reconciled to the accounts, line by line, so that the lender can see each step from one to the other.

DEFINED IN ONE PARAGRAPH → · THE CASH SIDE OF THE FORMULA → · THE COMPLIANCE CERTIFICATE →

// 05 — WHERE IT DECIDES A FILE

The definition is settled at the term sheet and the facility agreement, and it is easy to treat as boilerplate. It is not. A borrower that agrees a covenant level without reading what the level is applied to has agreed to a number it cannot yet calculate. A lender that wins a tight level but lets guarantees and deferred purchase price fall outside borrowings has a covenant that tests less than it appears to.

The definition matters again whenever the business changes shape. An acquisition with an earn-out, a new lease programme, a hedging position that moves against the business or a guarantee for a related company each changes the covenant result, or does not, according to the words. At a refinancing, a new lender's definition can move the ratio by a turn with nothing in the business changed, which is why the comparison between offers is made on a common definition.

DEBT TO EBITDA → · LOAN COVENANTS, EXPLAINED →

// SOURCES

The documents the statements on this page rest on. Each was opened and checked when cited.

IFRS Foundation, IFRS 16 Leases — overview of the standard — A lessee recognises assets and liabilities for all leases longer than 12 months unless the asset is of low value, for annual periods beginning on or after 1 January 2019 — section 02 and the FAQ.
Australian Accounting Standards Board, AASB 107 Statement of Cash Flows (August 2015), the Australian text of IAS 7 — paragraph 8 — Where an overdraft repayable on demand forms an integral part of cash management, it is included as a component of cash and cash equivalents — the double-counting point in section 02.
Financial Reporting Council, FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland (September 2024) — paragraph 7.22 and the Glossary entry 'net debt' — Defines net debt as borrowings with related derivatives and lease obligations, less cash and cash equivalents, requires an analysis of changes in it, and carries the lessee model that applies from 1 January 2026 — sections 01, 02 and 04.

// QUESTIONS PEOPLE ASK

What is included in net debt for covenant purposes?: Whatever the facility agreement's definition includes. Loans, overdrafts, bonds and finance leases are usually in. Guarantees of other parties' debt, deferred purchase price, hedging close-out amounts and receivables finance with recourse are often negotiated. Subordinated shareholder loans and ordinary trade credit are usually out. The cash deducted is normally limited to unrestricted cash the group can use, and may be capped. The only reliable answer for a given borrower is the definition in its own agreement.
Are lease liabilities included in net debt?: In the accounts, most leases are now liabilities: IFRS 16 has applied since 2019, and UK FRS 102 brings a similar model for periods beginning on or after 1 January 2026. In a covenant, it depends on the agreement. Many freeze the accounting basis at signing, counting only leases that were finance leases under the earlier rules and measuring EBITDA after rent. Others adopt the new basis and adjust the covenant level to match. The definition says which.
Is an earn-out counted as debt in a leverage covenant?: It depends on the wording. Some agreements count deferred purchase price as borrowing once it is fixed and payable, some count earn-outs only when they have been earned, and some exclude contingent consideration altogether. A lender's concern is that the payment will compete with debt service when it falls due, so it reads the earn-out's likely amount and timing whatever the covenant counts.
Why does net debt in the compliance certificate differ from the annual report?: Because they are built to different rules. The annual report's figure, where there is one, follows the current accounts: a management measure under IFRS, or the standard's own definition in UK accounts under FRS 102. The certificate's figure follows the facility agreement, which may freeze an older accounting basis, exclude restricted or capped cash, and add items such as guarantees. The certificate should reconcile the two so the lender can see each difference.

THE IN-TRAY · ONE MINUTE

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THE NUMBER · THE LOAN · CAPACITY

A company asks to refinance. Its year in four numbers:

EBITDA: US$6m
Capex + tax: US$2m
Interest: US$1m
Principal due: US$2m

What is its debt service cover, on cash available after capital spending and tax?

5 MORE ON THE LOAN · CAPACITY →WHERE DO YOU READ FROM? THE PLACEMENT →

THE GLOSSARYIN ONE PARAGRAPHNet debt (covenant definition) What counts as net debt in a leverage covenant?