Covenant headroom is the buffer you have between your company's current financial metrics and the limit stated in the loan agreement. It's a measure of how close to a breach you are right now. The smaller the headroom, the less room for negative surprises.
Example: Gearing limit in loan agreement: 3.5×. Current gearing: 3.2×. Covenant headroom: 0.3×.
Three ways to express headroom
- Absolute: The difference in metric units. E.g. 0.3× in gearing.
- Percentage: How much EBITDA can fall before breach. E.g. 12%.
- Time-based: Number of weeks to breach at current trend. E.g. 14 weeks.
The time-based version is often the most operational. It answers the question the board always asks: When?
Why is headroom more important than the metric itself?
Two companies can have the same gearing of 3.2× — but one can have stable EBITDA and be heading for a limit of 5.0×, while the other has falling EBITDA and a limit of 3.5×. The first has plenty of headroom. The second is facing a breach.
Headroom typically says more about your situation than the number itself.
What is healthy headroom?
There's no single right answer, but some rules of thumb:
- Under 10% headroom: Critical. A single bad month can trigger breach.
- 10–20% headroom: Pressured. Requires active monitoring and scenario planning.
- 20–40% headroom: Normal. Buffer for normal fluctuations.
- Over 40% headroom: Comfortable. The loan agreement doesn't constrain operations.
Headroom changes over time
Your headroom is not static. If EBITDA falls, headroom shrinks. If debt rises, headroom shrinks. That's why covenant monitoring isn't about one number once a quarter — it's about the trend. And the trend is what Covenant Horizon projects forward in time.