Most covenant breaches send signals before they occur. Here are the seven classic warning lights — the more that are flashing simultaneously, the greater the risk.
1. Declining EBITDA trend
EBITDA has fallen for two or three consecutive quarters. A single poor quarter is not necessarily alarming, but a trend is. Project the current trend forward — does it cross the covenant threshold?
2. Rising debt without corresponding EBITDA growth
Debt is growing — either because you're drawing on the credit facility, or because you've taken on new debt — but earnings aren't keeping pace. Gearing rises automatically.
3. Growing working capital
Inventory is rising. Receivables are taking longer to collect. Cash conversion cycle is expanding. This drains cash and increases drawdown on the credit facility.
4. Covenant headroom below 20%
If your gearing is close to the covenant threshold, your headroom may already be critically low. Any negative swing in a single month can trigger a breach.
Rule of thumb: Headroom below 20% requires active monthly monitoring. Below 10% requires weekly monitoring and a clear mitigation plan.
5. Falling gross margin
Even if revenue holds steady, gross margin is declining. Input prices are rising without the ability to pass them through, or discounts are being given to maintain sales. EBITDA takes a direct hit.
6. Increased reliance on overdraft facilities
You're drawing closer to the maximum on your overdraft. The facility is no longer used as a buffer but as permanent financing. This is a liquidity signal that often precedes covenant problems.
7. Gap between internal EBITDA and bank EBITDA
The company's own EBITDA looks fine — but the bank's definition is stricter. Some add-backs are not permitted. The difference can be substantial. Have you explicitly compared the two figures for the most recent quarter?
What should you do now?
If two or more of the above are present, you're in the risk zone. You should:
- Project your current trend forward and see where it lands
- Check precisely how the bank calculates your key ratios
- Assess how much runway you have for a downside case
- Consider opening a dialogue with the bank before a potential breach
The more of these signals you see together, the closer you are to a breach.