Covenant Headroom
Every quarter a leveraged borrower sends its lenders a compliance certificate: the ratios its credit agreement tests, against the levels it agreed. A ratio on its own says little. What a credit analyst wants is the headroom, how much EBITDA could fall before a test fails, and which test would fail first.
What is covenant headroom? The room between a borrower’s ratio and its covenant level, usually quoted as an EBITDA cushion: the share of EBITDA that could be lost, everything else held, before the test breaks. The smallest cushion across the tests is the borrower’s real headroom.
Three steps on one certificate, marked together. Then switch the credit model to its downside case and watch the same cushions turn negative.
The test period, $ millions
- EBITDA
- 120.0
- Net debt
- 600.0
- Cash interest
- 45.0
- Scheduled amortisation
- 30.0
- Capex
- 12.0
- Cash taxes
- 9.6
Step 1 · The three ratios
Net leverage is net debt over EBITDA. Interest cover is EBITDA over cash interest. Fixed charge cover is EBITDA less capex and cash taxes, over cash interest plus scheduled amortisation. Two decimals.
Step 2 · The test with the least room
For each test, how far could EBITDA fall, holding everything else, before it fails? The smallest of the three is the borrower’s real headroom. Pick the test and give that cushion as a percentage of EBITDA.
Step 3 · The downside
If EBITDA falls by 5% and nothing else changes, does the borrower still pass every test?
Keep going
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