Category D · Capital & Liquidity · Scenario 8
Covenant Headroom Shrinks
Many business loans include covenants — financial tests the business must pass, such as earning a certain multiple of its interest costs. If results weaken, you may get close to failing one. A breach can give the lender the right to change terms or demand repayment, so early warning matters.
Trigger
Forecast financial ratios approach your lender's covenant thresholds.
First move
Quantify the headroom, stress-test the forecast and engage your lender early.
Immediate first response
Calculate each covenant on your latest forecast using your lender's exact definitions, and see how much headroom remains.
First 24 hours
- Find your loan agreement and the exact covenant definitions
- Recalculate each covenant on actual and forecast figures
- Identify which covenant is closest to its threshold
Next 7 days
- Stress-test the forecast — what if earnings fall another 10–20%?
- Identify actions that genuinely improve earnings or reduce debt
- Prepare a clear explanation and plan for your lender
- Engage your accountant to check the calculations
Next 30 days
- Meet the lender before any breach occurs
- Negotiate a covenant reset or waiver if needed
- Implement earnings and cash improvement actions
- Report covenant headroom monthly to the board or owners
Typical causes
- Falling earnings from lower sales or margins
- Increased borrowing
- Higher interest rates
- One-off costs reducing earnings
- Covenants set too tightly at the outset
Early warning signs
- Monthly results tracking below the budget the covenants were set on
- Interest costs rising
- Forecast ratios getting closer to thresholds each quarter
- Lender asking more questions about results
Trigger indicators
- Forecast headroom on any covenant below 15–20%
- Two consecutive quarters of declining headroom
- Any forecast breach within the next 12 months
Financial implications
- EBITDA: earnings before interest, tax, depreciation and amortisation — a rough measure of operating earnings
- Interest cover: EBITDA (or EBIT) divided by interest expense
- Debt service cover: cash available for debt service divided by interest plus principal repayments
- Leverage: total debt divided by EBITDA
- Lender definitions vary — always use the wording in your agreement
Questions management should ask
- Which covenant is closest to breach, and in which quarter?
- Are we using the lender's exact definitions?
- What earnings fall would cause a breach?
- What actions would genuinely improve the ratio?
- When should we tell the lender — and what will we propose?
Common mistakes
- Waiting until after a breach to talk to the lender
- Using your own ratio definitions instead of the lender's
- Making accounting adjustments without real improvement
- Not forecasting covenants at all