Free tool · Covenant headroom · Educational
Monitor your loan covenants before the lender does
Covenants are tested on a schedule, but they deteriorate on a trend. A business that calculates its own ratios monthly sees a problem two quarters before the compliance certificate does — which is the difference between managing a conversation and receiving one.
What is covenant headroom?
Covenant headroom is the gap between your actual financial ratio and the level your credit agreement requires. A DSCR of 1.42x against a 1.25x minimum gives 0.17x of headroom — roughly a 12% decline in cash flow before the test fails. Headroom expressed as a tolerable decline is more useful than headroom expressed as a ratio.
What happens if a company breaches a loan covenant?
A breach is normally an event of default under the credit agreement, giving the lender contractual rights that can include demand for repayment. Most lenders respond first with a waiver, amendment, repricing, additional reporting or additional security. The specific consequences depend on your agreement — obtain legal advice on the actual document.
The calculator
Covenant headroom
Enter your calculated ratio, the level your agreement requires, and the cash flow the ratio is based on. Use the definitions in your own credit agreement — they vary.
For example, DSCR for the trailing twelve months.
As stated in the credit agreement.
Used to express headroom in dollars.
Headroom
0.17x
Workable headroom, but worth forecasting forward two quarters rather than reading it as comfortable.
Tolerable decline before breach: 12.0%
Equivalent cash-flow cushion: $85,599
Educational tool only. Covenant definitions, calculation periods and consequences are governed by your credit agreement. Nothing here is legal advice or an interpretation of your document; consult your legal advisor.
What gets tested
The covenants most commonly found in Canadian commercial credit
| Covenant | What it measures | What typically causes it to fail |
|---|---|---|
| Debt service coverage | Cash flow against principal and interest | Margin compression, a rate increase on floating debt, added amortization |
| Funded debt to EBITDA | Leverage relative to earning power | An earnings decline rather than new borrowing |
| Current ratio / working capital | Short-term liquidity | Receivables aging, inventory build, operating line drawn to the limit |
| Tangible net worth | Equity backing the facility | Losses, distributions, or intangible-heavy acquisitions |
| Capital expenditure limit | Discretionary investment | Committing to equipment without lender consent |
| Distribution restriction | Cash leaving the business | Dividends or shareholder repayments made while a test is tight |
Questions people ask
Covenants, answered directly
What is a loan covenant?+
A loan covenant is a condition in a credit agreement that the borrower must satisfy for the term of the facility. Financial covenants set measurable tests such as minimum debt service coverage, maximum leverage or minimum working capital. Non-financial covenants govern reporting, additional debt, asset sales and distributions.
What is covenant headroom?+
Covenant headroom is the distance between your actual ratio and the level the credit agreement requires. If your DSCR is 1.42x against a 1.25x minimum, the headroom is 0.17x. Expressed usefully, it is also the percentage decline in cash flow the business could absorb before breaching.
How often should covenants be calculated?+
Formally, on the schedule the credit agreement requires — usually quarterly or annually. Practically, monthly, using your own management figures. A covenant calculated only when the compliance certificate is due gives you no time to act on a trend that has been developing for two quarters.
What happens if a business breaches a loan covenant?+
A breach is typically an event of default under the credit agreement, which gives the lender rights that may include demanding repayment. In practice most lenders respond first with a waiver, an amendment, repricing, tighter reporting or additional security. Outcomes depend on the agreement and the relationship — obtain legal advice on your specific document.
Can a lender waive a covenant breach?+
Lenders often do, particularly where the breach is technical, temporary, disclosed early and accompanied by a credible remediation plan. A waiver is discretionary, is usually documented for a specific period, and frequently carries a fee or amended terms. It is also recorded on the file and read at renewal.
How can a business avoid a covenant breach?+
Calculate the covenant monthly on the agreement's own definitions, forecast it forward one to two quarters, and act on the trend rather than the breach. Where headroom is narrowing, the useful levers are deferring discretionary spending and distributions, accelerating collections, and opening the conversation with the lender before the certificate is due.
Related: DSCR calculator, commercial loan renewal timeline, and 13-week cash-flow forecasting.
Know what the lender will see before the lender sees it.
The Capital Health Monitor calculates your covenants monthly against the definitions in your own agreement and flags a narrowing trend while there is still time to act.
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