How do you calculate covenant headroom?

For a maximum leverage test, divide net debt by the covenant level to find the lowest EBITDA that still passes, then compare it with actual EBITDA. With net debt of US$30m, a covenant of 4.0 times and EBITDA of US$10m, the lowest passing EBITDA is US$7.5m, so earnings can fall 25%. For a minimum test such as interest cover, the shortcut is one minus the covenant divided by the actual ratio. Use the agreement's definitions, not the statutory accounts.

How much covenant headroom is normal?

There is no standard figure. Headroom is negotiated from the borrower's forecast, and it differs with the type of lender, the deal and how volatile the business is. A steady business can live with less than a cyclical one. The useful question is not what percentage others get but what bad year the cushion would absorb, which is why lenders run a downside case through the test and allow for the debt that a bad year tends to add.

What happens when covenant headroom runs out?

If the test fails, the breach is usually an event of default, or becomes one after any cure period, which gives the lender rights under the agreement. In practice the usual sequence is a conversation, followed by a waiver for that test, a reset of the level or additional owner equity where the agreement permits it. Fees, a higher margin and more frequent reporting are common prices. A borrower that raises thinning headroom before the test date starts from a stronger position.

Do EBITDA add-backs increase covenant headroom?

Yes, on paper. If the agreement lets the borrower in this page's example add back US$1m of costs, covenant EBITDA becomes US$11m, leverage falls to 2.73 times and earnings headroom rises from 25% to about 32%. No more cash has been earned. That is why lenders cap add-backs and read the adjusted and unadjusted figures side by side: the gap between them shows how much of the cushion comes from the definition rather than the business.

// WORKED EXAMPLETHE ARITHMETIC A DECISION RESTS ON

Covenant Headroom: a Worked Example

The percentage depends on which number you let move.

BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED 2026-11-09 · 6 MIN READ

// THE SHORT ANSWER

A leverage covenant at 4.0 times tells a lender little until it knows how far the borrower sits from it. Covenant headroom turns that gap into something that could happen to the business: how far earnings could fall, or how much debt could rise, before the test fails. The same gap gives different percentages depending on which number moves, and bad years tend to move both. A borrower with 25% of earnings headroom can lose most of it to a smaller fall in profit if slower cash collection pushes debt up at the same time.

BASIS Practitioner judgment from sixteen years in commercial banking, set out in How Bankers Think (Highbank Press, 2026). Every borrower on this site is a composite constructed for teaching, not a client. The market is mid-market commercial lending as practised in New Zealand and Australia; where a convention differs elsewhere, the page says so.

// MAKE THE CALL

Issue 04 — Highview Industries. Same request as Issue 01 on the surface. A completely different file underneath. Your call first, then the senior banker's.

Read the file →

PART OF Loan Covenants, Explained

// 01 — WHAT THE LENDER IS MEASURING

A financial covenant draws a line. On its own the line says little: a maximum of 4.00 times means one thing for a borrower at 3.90 and another for a borrower at 2.50. What a lender wants from each compliance certificate is the distance from the line, stated as an event in the business rather than as a gap between two ratios.

That distance does a different job for each side. For the borrower it is room to have an ordinary bad quarter without asking anyone's permission. For the lender it sets how early the covenant speaks: too wide and the test fails after the damage is done, too tight and credit staff spend their time on a business with nothing wrong with it. Where the line goes is negotiated deal by deal, usually from the borrower's forecast. Nothing in New Zealand, Australian or UK law sets it.

// 02 — THREE WAYS TO STATE ONE CUSHION

Maximum test (debt ÷ earnings)

Ratio headroom = covenant − actual

Earnings headroom = 1 − (actual ÷ covenant)

Debt headroom = (covenant ÷ actual) − 1

Minimum test (earnings ÷ charges)

Ratio headroom = actual − covenant

Earnings headroom = 1 − (covenant ÷ actual)

Earnings headroom is the figure most readers want, because earnings are what usually move. Debt headroom is the one to read before a new drawing or an acquisition. A report that says "25% headroom" has to say of what. On a maximum test the ratio gap as a share of the covenant happens to equal the earnings figure. On a minimum test it does not: cover of 5.0 times against a floor of 3.0 is a gap worth 67% of the covenant, yet earnings can fall only 40%.

Every input belongs to the agreement rather than the accounts. The net debt definition decides what is counted as debt and how much cash comes off. The EBITDA definition and its add-backs decide the earnings, and LTM EBITDA decides the period. Headroom worked on the statutory figures can be a long way from headroom on the covenant's own.

// 03 — THE EXAMPLE

A contract manufacturer of vitamin and supplement tablets, constructed for this page like every figure in it, has net debt of US$30m, twelve-month EBITDA of US$10m and annual interest of US$2m. Its agreement sets maximum net leverage of 4.00 times and minimum interest cover of 3.00 times. Both levels belong to the example and are not offered as a market norm.

Net leverage 30 ÷ 10 = 3.00× covenant 4.00×

Ratio headroom 4.00 − 3.00 = 1.00×

Lowest EBITDA 30 ÷ 4.00 = 7.5 can fall 2.5, or 25%

Highest debt 10 × 4.00 = 40 can rise 10, or 33%

Interest cover 10 ÷ 2 = 5.00× covenant 3.00×

Lowest EBITDA 2 × 3.00 = 6.0 can fall 4.0, or 40%

The tighter test governs, so the manufacturer has 25% of earnings headroom. Now suppose it loses a large customer. EBITDA falls 15% to US$8.5m, and unsold stock and slower collections absorb US$3m of cash, taking net debt to US$33m. Interest is held at US$2m to keep the example simple.

Net leverage 33 ÷ 8.5 = 3.88×

Lowest EBITDA 33 ÷ 4.00 = 8.25

Earnings headroom (8.5 − 8.25) ÷ 8.5 = 2.9%

Interest cover 8.5 ÷ 2 = 4.25× still comfortable

Read one number at a time and a 15% fall seems to use three-fifths of a 25% cushion. It used nearly all of it, because the trouble that cut earnings also raised debt. Anything beyond a further US$0.25m off EBITDA would fail the test. The interest cover covenant, meanwhile, is telling the lender that nothing much has happened.

// 04 — HOW IT DIFFERS, AND WHAT MOVES IT

Liquidity headroom is the neighbour most often confused with it. Liquidity headroom counts the cash and committed lines available to pay bills. Covenant headroom measures the distance to a contractual trigger. The two can part company: a business can pass every test with its accounts nearly empty, or fail a test with money in the bank. They also connect, since many agreements stop further drawings once a default exists, and undrawn lines counted as liquidity can vanish on the day a covenant fails.

Headroom also has a calendar. A step-down reduces it with nothing having happened: on the example's opening figures, a covenant stepping to 3.50 times cuts earnings headroom from 25% to 14.3%. And it is read on a test date. Seasonal borrowing can make one test the least flattering day of the year, so a thin reading sends a lender to the calendar before it concludes anything about the business.

DEFINED IN ONE PARAGRAPH → · LIQUIDITY HEADROOM → · THE TEST DATE →

// 05 — WHERE IT DECIDES A FILE

At origination, a lender runs its downside case through the proposed covenants and looks at which test fails first and in which quarter. Over the life of the loan it reads the trend: three certificates of shrinking headroom carry more information than one pass. When the cushion runs thin, the choice is between a covenant waiver, a reset or, where the agreement allows one, an equity cure, and those conversations go better before the test date than after it.

Thin headroom can now reach the accounts as well. Companies on the IFRS-based standards in New Zealand and Australia, reduced-disclosure (Tier 2) reporters included, must disclose the covenants they have to meet within twelve months on loans classified as non-current, along with any facts suggesting they may struggle to comply. FRS 102 in the UK has no equivalent note: it asks only about a breach or default left unremedied at the reporting date. Private companies outside these frameworks may publish none of this, so the lender's own calculation remains the reading it relies on.

LOAN COVENANTS, EXPLAINED → · COVENANT WAIVER →

// SOURCES

The documents the statements on this page rest on. Each was opened and checked when cited.

Australian Accounting Standards Board, AASB 2022-6 Amendments to Australian Accounting Standards – Non-current Liabilities with Covenants (the Australian text of the IASB's 2022 amendment to IAS 1) — paragraph 76ZA — Requires disclosure that lets readers understand the risk that non-current loans with covenants to be met within twelve months could become repayable, the disclosure described in section 05; AASB 2023-3 carries it into AASB 1060 for Tier 2 reporters.
External Reporting Board (New Zealand), NZ IAS 1 Presentation of Financial Statements — paragraph 76ZA — Sets the same disclosure in New Zealand, with no reduced-disclosure concession marked on the paragraph — section 05.
Financial Reporting Council, FRS 102 (September 2024 edition) — paragraph 11.47 — Requires disclosure of a breach or default on loans payable not remedied by the reporting date, the UK position in section 05.

// QUESTIONS PEOPLE ASK

How do you calculate covenant headroom?: For a maximum leverage test, divide net debt by the covenant level to find the lowest EBITDA that still passes, then compare it with actual EBITDA. With net debt of US$30m, a covenant of 4.0 times and EBITDA of US$10m, the lowest passing EBITDA is US$7.5m, so earnings can fall 25%. For a minimum test such as interest cover, the shortcut is one minus the covenant divided by the actual ratio. Use the agreement's definitions, not the statutory accounts.
How much covenant headroom is normal?: There is no standard figure. Headroom is negotiated from the borrower's forecast, and it differs with the type of lender, the deal and how volatile the business is. A steady business can live with less than a cyclical one. The useful question is not what percentage others get but what bad year the cushion would absorb, which is why lenders run a downside case through the test and allow for the debt that a bad year tends to add.
What happens when covenant headroom runs out?: If the test fails, the breach is usually an event of default, or becomes one after any cure period, which gives the lender rights under the agreement. In practice the usual sequence is a conversation, followed by a waiver for that test, a reset of the level or additional owner equity where the agreement permits it. Fees, a higher margin and more frequent reporting are common prices. A borrower that raises thinning headroom before the test date starts from a stronger position.
Do EBITDA add-backs increase covenant headroom?: Yes, on paper. If the agreement lets the borrower in this page's example add back US$1m of costs, covenant EBITDA becomes US$11m, leverage falls to 2.73 times and earnings headroom rises from 25% to about 32%. No more cash has been earned. That is why lenders cap add-backs and read the adjusted and unadjusted figures side by side: the gap between them shows how much of the cushion comes from the definition rather than the business.

// NEXT TO IT

// ON WHOSE DESK

The seats that read this term in an ordinary week. Each page says what the seat is for, who arrives in it, and the shape of the round it runs.

Credit sanctionerHolds delegated authority and signs — or declines — the lending the front line brings.
Legal counselAdvises the bank on what it can do, drafts and negotiates what it signs, and manages what goes wrong.
Portfolio managerOwns the credit on a book after the money is out — reviews, covenants, ratings and early warning.

THE IN-TRAY · ONE MINUTE

Make the call on one file.

A short file on the ground this page covers. Every option opens with how far it sits from a senior banker’s read.

THE FIRST QUESTION · THE LOAN · PROTECTION

A wholesaler's stock is the bank's main security. Its main supplier's terms say goods remain the supplier's property until they are paid for.

What does that clause do to the bank's security?

7 MORE ON THE LOAN · PROTECTION →WHERE DO YOU READ FROM? THE PLACEMENT →

THE READING ROOMIN ONE PARAGRAPHCovenant headroom What is covenant headroom, and why does the test date matter as much as the ratio?