Headroom in EBITDA, in debt and in turns, why they are three different numbers, and what add-backs, cash and a step-down do to each.
Covenant headroom on a leverage covenant is the amount EBITDA can fall before the ratio hits the covenant level: EBITDA minus net debt divided by the covenant. At an illustrative €216.0m of net debt, €48.0m of Consolidated EBITDA and a 5.50x covenant, EBITDA can fall to €39.27m, so headroom is €8.73m, 18.2 per cent. Take out €6.0m of add-backs and it is €2.73m, 6.5 per cent.
Worked in full in How to Read a Credit Agreement by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A sponsor-backed borrower reports its quarterly compliance certificate: total net leverage of 4.50x against a maximum of 5.50x, with the covenant stepping down to 5.00x in four quarters. The lender's portfolio team wants headroom expressed in a way the credit committee can act on. All figures are illustrative, in € millions, last twelve months.
| Input | Value |
|---|---|
| Consolidated EBITDA as defined (LTM) | 48.0 |
| of which pro forma cost savings and synergies | 6.0 |
| Gross debt | 236.0 |
| Unrestricted cash netted | 20.0 |
| Net debt | 216.0 |
| Net leverage covenant, now / in four quarters | 5.50x / 5.00x |
The ratio. 216.0 / 48.0 = 4.50x, one turn inside the covenant.
EBITDA headroom. Hold net debt constant and solve for the EBITDA at which leverage equals the covenant: 216.0 / 5.50 = 39.27. EBITDA can fall by 8.73 before a breach.
EBITDA headroom = EBITDA − Net debt / Covenant = 48.0 − 39.27 = 8.73
EBITDA cushion = 1 − Leverage / Covenant = 1 − 4.50 / 5.50 = 18.2%
Excel: =1-NetDebt/(Covenant*EBITDA)
Debt headroom. Hold EBITDA constant instead: net debt could rise to 5.50 × 48.0 = 264.0, an extra 48.0, or 22.2 per cent. That is the capacity question (how much more can be borrowed or spent) rather than the default question (how much can trading fall), and it is a larger percentage for the same turn.
Over a single quarter the picture is starker. EBITDA is tested on twelve months, but it falls a quarter at a time. If the latest quarter contributed 12.0, the 8.73 of headroom means that quarter can lose 72.7 per cent of its earnings before a breach, or the next four quarters can each lose 18.2 per cent.
The €6.0m of pro forma savings in Consolidated EBITDA is real money for covenant purposes and imaginary money for debt service. Strip it out and EBITDA is 42.0, leverage 5.14x, and headroom 2.73, only 6.5 per cent. More than two thirds of the reported headroom is the add-back.
Then the step-down. At 5.00x the minimum EBITDA becomes 43.20: headroom on reported EBITDA falls to 4.80, 10.0 per cent, and on EBITDA without add-backs it is negative, −1.20. If the savings have not arrived and the add-back has run off by the time the covenant steps down, the borrower is in breach on unchanged trading.
| Covenant | Minimum EBITDA | Headroom, as reported | Cushion | Headroom, no add-backs | Cushion |
|---|---|---|---|---|---|
| 6.00x | 36.00 | 12.00 | 25.0% | 6.00 | 14.3% |
| 5.50x | 39.27 | 8.73 | 18.2% | 2.73 | 6.5% |
| 5.00x | 43.20 | 4.80 | 10.0% | −1.20 | −2.9% |
| 4.75x | 45.47 | 2.53 | 5.3% | −3.47 | −8.3% |
How large the add-back is allowed to be, and when it runs off, is therefore as much a covenant term as the 5.50x itself. What an EBITDA add-back bridge is worth in leverage turns works through the same mechanism from the underwriting side.
Net leverage nets cash, so headroom also depends on the borrower not spending it. Use the €20.0m on a bolt-on or a distribution permitted under the baskets and net debt becomes 236.0: leverage 4.92x and an EBITDA cushion of 10.6 per cent. Nothing about the business has changed and nearly eight points of headroom have gone. A lender reading the certificate should check what the baskets allow the cash to be used for before treating it as protection.
The common mistake is reporting headroom in turns. "One turn of headroom" sounds like a fixed amount of safety, but at 4.50x against 5.50x it is an 18.2 per cent EBITDA fall and at 3.00x against 4.00x it is 25.0 per cent. The second mistake is mixing the two percentages: the 22.2 per cent debt headroom and the 18.2 per cent EBITDA cushion describe the same turn, and quoting the larger one as the distance to default overstates it. State headroom in currency of EBITDA, as a percentage of EBITDA, with and without add-backs, at the current and the next covenant level. That is four numbers, and a committee can act on all of them.
Setting headroom at closing is the same formula run backwards: a covenant with 30 per cent headroom to model leverage of 4.50x is 4.50 / (1 − 0.30) = 6.43x.
The book shows headroom in EBITDA rather than turns for the same reason, and the free workbook for this case runs it quarter by quarter on a complete facility, where moving the add-back cap brings three quarters back into compliance. If the headroom runs out, the price of the remedy is in how much equity a covenant cure needs.
Covenants in leveraged loans are often set with somewhere around 25 to 35 per cent EBITDA headroom to the sponsor's base case, illustratively. The level follows from the formula covenant = model leverage / (1 minus headroom): at 4.50x model leverage and 30 per cent headroom that is 6.43x. The headroom then erodes as the covenant steps down faster than the plan deleverages.
It depends on where it starts. One turn between 4.50x and 5.50x lets EBITDA fall 18.2 per cent; one turn between 3.00x and 4.00x lets it fall 25.0 per cent. Turns are a poor unit for headroom because the same turn means a different EBITDA fall at every leverage level. State it in currency and in per cent of EBITDA.
Under a net leverage covenant, yes, if it meets the agreement's definition of unrestricted cash and any netting cap. That makes headroom fragile: spending the €20.0m of cash in this example on an acquisition or a dividend takes leverage from 4.50x to 4.92x and EBITDA headroom from 18.2 to 10.6 per cent without any change in trading.
This article is one calculation from How to Read a Credit Agreement. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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