Guide
Covenant headroom
Covenant headroom is the distance between where a financial covenant test lands and where it would fail. Boards usually see one number, at quarter end. The real risk tends to sit between quarter ends, and in definitions nobody re-read.
Common financial covenants
| Covenant | Typical test | What it protects |
|---|---|---|
| Leverage | Net debt ÷ EBITDA ≤ x | Debt capacity |
| Interest cover | EBITDA ÷ interest ≥ x | Ability to pay interest |
| Fixed-charge cover | (EBITDA − capex) ÷ (interest + scheduled repayments) ≥ x | Ability to service debt |
| Minimum liquidity | Cash + undrawn facility ≥ $x | Running out of cash |
| Capex limit | Capex ≤ $x per year | Cash leakage |
Each term (EBITDA, net debt, interest) is defined in the facility agreement. The definitions often differ from the accounting ones, and they matter.
Worked calculation (fictional)
Facility leverage covenant: ≤ 3.50×.
Net debt (facility definition) $105m
EBITDA (facility definition, LTM) $33m
Leverage 3.18x
Headroom to 3.50x on EBITDA:
EBITDA could fall to $105m ÷ 3.50 = $30.0m
Headroom = ($33m − $30m) ÷ $33m = 9.1%
A 9% EBITDA miss breaches. That's the number a board should see, with the trend.
What boards miss
Testing on the wrong definition. Management accounts EBITDA can include items the facility excludes, or the reverse.
Seasonal troughs. A business can pass every quarter-end test and still breach a minimum-liquidity covenant mid-quarter, or need a revolver draw the lender can refuse.
Adjustments the lender may reject. Pro forma savings and add-backs are often capped in the agreement.
Cure rights assumed. An equity cure may be available, or may be limited in number and timing.
Presenting headroom honestly
- Show the test, the result, the threshold and the headroom as a percentage of EBITDA.
- Use the facility's definitions and cite the clause.
- Show forecast headroom for the next four test dates, plus the 13-week liquidity trough.
- Label any add-back the lender hasn't accepted.
On the desk
Attach the facility agreement and the compliance certificate to a matter. Ask "What is covenant headroom on the facility definitions in this file?". If the agreement isn't attached, that's the first gap the desk names. Jurisdiction is named, and statute-level conclusions are marked Requires Local Validation. For a legal reading of the agreement, LIA Pro is the desk. With an FIA Plan seat, you can send it an FIA Brief.
A note on forecasting headroom
Forecast headroom is only as good as the forecast EBITDA behind it. Show the base case, and the EBITDA level at which each covenant breaks. Directors can then judge the distance for themselves.
Questions
What is covenant headroom?
The margin by which a borrower passes a financial covenant test, often shown as the percentage EBITDA could fall before a breach.
Why does working capital matter for covenants?
Liquidity needs peak between test dates. A business can pass leverage tests while running short of cash in its trough.
Is CFO Sentinel's reading of my facility legal advice?
No. It is decision support. Facility interpretation needs counsel.