Module IV· Debt RatiosIntermediate
Question
What is 'covenant headroom' and why is it critical?
Answer
Mechanics
Covenant headroom = the difference between the current ratio and the contractual limit. It measures the room for an EBITDA decline or a debt increase.
Deep diveShow more details
Example
| Item | Value |
|---|---|
| Senior Debt / EBITDA current | 4.5x |
| Maintenance covenant limit | 5.5x |
| Headroom (absolute) | 1.0x |
| Headroom (%) | 22% |
| Implied EBITDA-decline tolerance | ~18% (reverse math) |
Consequence
At 22% headroom, EBITDA can fall ~18% before the covenant is breached. At 10% headroom, the tolerance is only 9% — very tight, every quarterly weakness is critical.
Rule of thumb
| Headroom | Assessment |
|---|---|
| > 30% | Comfortable — sponsor can reinvest |
| 20-30% | Standard — healthy |
| 10-20% | Tight — early-warning mode |
| < 10% | Critical — equity cure or restructuring looms |
Common pitfalls
- The covenant test is typically on LTM EBITDA (not the current quarter) — visible with a lag
- The "cure period" is often 30 days — but too short for real performance improvement
Pitch tip
Question: "How high should initial headroom be?"
Answer: "Typically 25-35% at closing. The sponsor negotiates for more (40%+), the lender wants less (15-20%). Middle-market standard: 30%"