Covenant Headroom Checker

The chain, written out

Three steps. Each one is a division, and the whole thing takes a minute on paper once you have the cost split.

Step one: contribution margin

Split the cost base into variable and fixed. Contribution is revenue less variable cost. Contribution margin is that over revenue. The judgement that matters most is the variable percentage, and it is almost always lower than the accounting classification suggests. Test it rather than assuming it: plot revenue against cost month by month across the last downturn, and the slope of that line is your true variable share.

Step two: degree of operating leverage

Contribution divided by EBITDA. It tells you how many times a revenue movement is amplified by the time it reaches earnings. At 3.5 times, an eight percent revenue fall is a twenty eight percent earnings fall.

Step three: the conversion

Your EBITDA tolerance is the distance between current EBITDA and the minimum the covenant permits, which is net debt divided by the covenant ratio. Divide that tolerance by the degree of operating leverage and you have the revenue decline that breaches.

Why the breach comes through the denominator

Nothing happens to the debt. It does not grow, and nobody does anything wrong on the balance sheet. Earnings fall, the ratio moves because the number underneath it moved, and the covenant is breached by arithmetic rather than by an event. That is why it surprises people: there is no moment where anything visibly goes wrong.

What to do with the number

Put it on the first page of the monthly pack, in this form: revenue at covenant breach, current forecast, headroom as a percentage. A sales director who knows that number behaves differently from one who does not, and a commercial team that has never been told it has no way to weigh a discount against the risk it creates.

Limits worth stating

This assumes the covenant is tested on net debt to EBITDA, that net debt holds while EBITDA moves, and that your variable share stays constant as revenue falls. In practice the variable share often falls in a downturn, because notice periods and rehiring costs make labour behave as a fixed cost over any period shorter than about nine months. That makes the real position worse than this shows, not better. Interest cover and fixed charge cover covenants work differently and are not modelled here.