Third quarter compliance certificates are coming due. A lot of middle market credit agreements give you around 45 days after quarter end, some give you 60, and if nobody has opened yours since closing, this would be a good week to do it. The certificate itself is easy enough to fill in. The trouble is that the number it produces, a ratio sitting under a limit, is a pretty poor guide to how much room you have. So here's how to calculate covenant headroom in a form you can do something with.
Ratio headroom vs EBITDA headroom
Say your agreement caps total debt to EBITDA at 4.00x. You carry $60 million of funded debt against $17.6 million of trailing twelve month covenant EBITDA, which puts you at 3.41x. Compliant. The usual way to report the headroom is 0.59 turns, and I'm not sure anyone outside the finance team knows what to do with that.
Turn it into dollars instead. With $60 million of debt you breach when EBITDA falls below $15.0 million ($60 million divided by 4.00), so you have $2.6 million of EBITDA cushion, roughly 15%. If your contribution margin is around 30%, that cushion is about $8.7 million of lost revenue before you're in trouble. The revenue version tends to get your sales leader's attention fast, especially if one large account has been looking wobbly lately.
You can also run it in reverse to see borrowing room. Four times $17.6 million is $70.4 million, so you could take on roughly another $10 million before the test bites, assuming EBITDA holds where it is.
The fixed charge coverage ratio covenant gets squeezed from both sides
Fixed charge coverage is the covenant that tends to surprise people in a year like this one. Definitions vary, so check yours, but it's usually some version of EBITDA less unfinanced capex, cash taxes and distributions, divided by cash interest plus scheduled principal. Say that comes to $12.0 million over $8.5 million, or 1.41x, against a 1.25x minimum. The top line can drop to about $10.6 million before you breach, which leaves a cushion of roughly $1.4 million, or 11.5%.
And the Fed raised rates in September. If most of your debt floats, the bottom of that fraction went up without anyone touching the model, and a soft quarter would push the top down at the same time. Your debt to EBITDA ratio won't notice the rate change at all, which is part of why fixed charge coverage is so often the test that gets tight first when rates are rising.
Look four test dates out, not one
Covenant EBITDA is almost always trailing twelve months, so next quarter's headroom depends as much on what drops off as on what you earn. If last year's fourth quarter was the best you've ever had, it rolls out of the calculation when this year's fourth quarter rolls in, and a perfectly respectable quarter can still leave you with less cushion than you started with. Run your forecast through the covenant model and compute headroom for each of the next four test dates, of which the one due next month is probably the least interesting.
While you're in there, rebuild the calculation from the definitions section of the credit agreement rather than from last quarter's spreadsheet. Addbacks drift over time. Somebody added back a one-time cost three quarters ago that the agreement caps, or a lease got reclassified, and the spreadsheet has carried it forward ever since because nobody has reopened the PDF since closing, which happens more often than anyone likes to admit.
How much headroom is enough, and when to call the bank
Lenders set the cushion at closing, and it has drifted wider over the years. Writing about European private credit in 2023, Proskauer described typical headroom at signing as 30% or more, up from roughly 25% historically. I don't know of a good rule for what's safe after that. My own rough line is somewhere around 15%: once any upcoming test date dips below it, I'd talk to the relationship manager before the certificate goes in.
Conditions are friendlier than they could be. Lincoln International's second quarter private market index put the covenant default rate at 2.7%, down from 3.1% in the first quarter, and the Fed's July senior loan officer survey found banks' standards on commercial and industrial loans basically unchanged, with the banks that did ease mostly pointing to competition from other banks and nonbanks. A lender competing for business is usually happy to talk through an amendment with a borrower who calls early with a plan, and a good deal less relaxed about it if the first they hear is the certificate itself.
Max De Pree, who ran Herman Miller for years, wrote that the first responsibility of a leader is to define reality. Covenants are about as literal a version of that as finance gets, since the CFO is the one person who can see where the company stands against the test a quarter ahead, and the bank otherwise works it out from the certificate after the fact.
What to do this week
- Rebuild the covenant math from the agreement's own definitions, line by line, addback caps included.
- Put headroom in EBITDA dollars and as a percentage, then translate it into revenue using your contribution margin.
- Run the next four test dates off your forecast, plus a downside where your largest customer orders 20% less.
- Read your cure rights. In the US, equity cures are commonly limited to two in any twelve month period, according to Proskauer's review, and your agreement may be stricter.
- If any test date looks thin, set up the lender call now and bring the forecast along with what you're doing about it. I wrote more about talking to lenders before you need them.
Covenant terms for private companies are one of the things outside research almost never turns up, which means you're the only person who can see this number early. A free briefing shows the outside events most likely to move the EBITDA side of the calculation, and your 13-week cash flow forecast covers liquidity.
CFOmarketIQ reads the week's news against your own debt and margins, and the first briefing is free.
Questions CFOs ask about covenant headroom
How do you calculate covenant headroom?
Divide your funded debt by the maximum debt-to-EBITDA ratio. That gives you the lowest EBITDA you can report without breaching. Subtract it from your actual covenant EBITDA to get the cushion in dollars, and divide by actual EBITDA for a percentage. Repeat for each covenant, using the definitions in your own credit agreement.
How much headroom should you have on a debt covenant?
Lenders often set 25% to 30% or more of cushion at closing. Nobody publishes a safe level for after that. As a rough line, once headroom on an upcoming test date drops under about 15%, it's worth calling your lender before the compliance certificate is due.
What happens if you breach a debt covenant?
A breach is usually an event of default. That lets the lender charge default interest, stop new borrowing or, at worst, accelerate the loan. Most breaches end with a waiver or an amendment, typically with a fee, tighter terms or a wider spread attached, and those tend to be cheaper when you raise the problem early.
What is an equity cure?
An equity cure lets the owners put in cash that counts toward EBITDA, or sometimes toward paying down debt, so the company passes a covenant test it would otherwise fail. Agreements limit how often you can use it, commonly no more than two cures in any twelve months and only a handful over the life of the loan.
A note on all of this: it is general information, not financial, legal or tax advice. Run anything you plan to act on past your own advisors first.