Step-by-Step Calculation & Covenant Setting Guide
Covenants are contractual restrictions and requirements in debt agreements that protect lenders by limiting risky actions and ensuring borrowers maintain minimum financial health.
Think of covenants as an early warning system. They're designed to trigger BEFORE a company gets into serious trouble, giving lenders the ability to intervene, renegotiate terms, or demand repayment while there's still value to protect.
Tested: Quarterly (every 3 months)
Used in: Bank loans, traditional credit facilities
Example: "Total Debt / EBITDA must be ≤ 5.0x"
Risk: Can trigger even during temporary downturns
Tested: Only when taking specific actions
Used in: High yield bonds, covenant-lite loans
Example: "Can only borrow more if Fixed Charge Coverage > 2.0x"
Benefit: More operational flexibility
| Covenant Type | Formula | Typical Range | What It Protects |
|---|---|---|---|
| Total Leverage | Total Debt ÷ EBITDA | ≤ 4.0x to 6.0x | Overall debt burden relative to earnings |
| Senior Leverage | Senior Debt ÷ EBITDA | ≤ 3.0x to 5.0x | Senior lenders from being diluted by junior debt |
| Interest Coverage | EBITDA ÷ Interest Expense | ≥ 2.0x to 4.0x | Ability to service interest payments |
| Fixed Charge Coverage | EBITDA ÷ (Interest + Principal + CapEx + Taxes) | ≥ 1.1x to 1.5x | Ability to meet all fixed obligations |
| Debt Service Coverage | Cash Flow ÷ (Principal + Interest) | ≥ 1.2x to 1.5x | Cash generation vs debt payments |
Lenders use multiple covenants because they protect against different risks:
• Leverage ratios ensure debt doesn't grow too large relative to earnings
• Coverage ratios ensure cash flow is sufficient to pay debt service
• Minimum EBITDA ensures earnings don't fall below absolute threshold
A company could pass leverage tests but fail coverage tests if EBITDA is growing but interest costs are growing faster. Having multiple tests provides comprehensive protection.
Company prepares financial statements and calculates covenant ratios per credit agreement definitions
CFO signs certificate attesting to covenant compliance and showing calculations
If any ratio violates limits → Immediate Event of Default (even if paying interest on time)
• Waive breach (usually with fees)
• Amend covenant (tighten other terms)
• Demand immediate repayment
• Increase interest rate
• Take control/force restructuring
Let's walk through exactly how to calculate each major covenant type using a concrete example company.
• EBITDA adjustments are CRITICAL - they can add 10-20% to EBITDA
• Credit agreements spell out exactly which add-backs are allowed
• Synergies from acquisitions are usually capped (e.g., max 15% of EBITDA)
• Some agreements allow netting cash, others don't
• If covenant is "≤ 5.0x" and you're at 3.15x → you have 1.85x of headroom
Note: This is calculated similarly to Total Leverage but with only senior debt in the numerator.
Senior lenders want protection from being diluted by junior debt. If Total Leverage limit is 5.0x and Senior Leverage limit is 3.5x, the company can only add 1.5x of junior debt (second lien, mezzanine, etc.). This ensures senior lenders remain well-protected.
3.74x means: For every dollar of interest expense, the company generates $3.74 of EBITDA.
Typical minimums:
• Strong credit: ≥ 3.0x
• Moderate credit: ≥ 2.5x
• Weak/LBO credit: ≥ 2.0x
• Below 2.0x = high default risk
At 3.74x with a 2.5x minimum, you have 1.24x cushion → comfortable headroom
Notice our Interest Coverage was 3.74x but Fixed Charge Coverage is only 1.69x. That's because FCCR includes:
• Principal repayments (not in interest coverage)
• Taxes (cash going out the door)
• Sometimes CapEx (necessary spending)
This gives a more realistic picture of "can you actually pay all your obligations?" Typical minimums are 1.1x to 1.5x because the denominator is much larger.
Note: DSCR is similar to FCCR but focuses specifically on principal + interest. It's common in real estate and project finance.
DSCR is most common in asset-based lending where cash flow predictability matters:
• Real estate: Property generates rent, must cover mortgage
• Project finance: Infrastructure project must cover construction debt
• Equipment leasing: Lease payments must cover debt service
Minimum thresholds are typically 1.20x to 1.50x.
Setting covenant levels is both art and science. Lenders want protection but borrowers need operational flexibility. Let's walk through the negotiation process step-by-step.
Calculate ratios for past 8-12 quarters. Identify:
• Historical highs and lows
• Seasonal patterns
• Trend direction
• Tightest quarter
Model forward 4-8 quarters using management's forecast:
• Calculate pro forma ratios quarterly
• Identify tightest quarter going forward
• Determine minimum cushion needed
Model adverse cases:
• 10-15% revenue decline
• Margin compression
• Working capital deterioration
• Interest rate increases
Decide minimum cushion:
• Conservative: 20-25% headroom
• Moderate: 15-20% headroom
• Aggressive: 10-15% headroom
Depends on credit quality and relationship
Based on tightest quarter + required headroom:
Example: Tightest Total Leverage = 4.2x
+ 20% headroom = 5.0x covenant level
Borrower pushes back, iterative process:
• Adjust levels
• Add step-downs over time
• Agree on EBITDA add-backs
• Define springing covenants
Transaction: PE firm acquiring TechCo for $200M
Financing: $120M senior debt, $30M second lien, $50M equity
LTM EBITDA: $40M (post-transaction)
Projected EBITDA: Growing 8% annually
| Quarter | EBITDA (TTM) | Total Debt | Total Leverage |
|---|---|---|---|
| Q1 2024 | $38M | $160M | 4.21x |
| Q2 2024 | $39M | $158M | 4.05x |
| Q3 2024 | $40M | $155M | 3.88x |
| Q4 2024 (Close) | $40M | $150M | 3.75x |
| Quarter | EBITDA (TTM) | Total Debt | Total Leverage | Notes |
|---|---|---|---|---|
| Q1 2025 | $39M | $153M | 3.92x | Seasonal dip + working capital build → TIGHTEST QUARTER |
| Q2 2025 | $41M | $151M | 3.68x | Revenue recovers, principal amortization |
| Q3 2025 | $42M | $148M | 3.52x | Strong quarter |
| Q4 2025 | $43M | $145M | 3.37x | Year-end peak |
Base Case (Q1 2025): 3.92x (tightest quarter)
Downside Case: 5.00x
Option A - Conservative: Set at 4.50x
• Base case headroom: 15% (4.50 - 3.92 = 0.58)
• Could withstand ~12% EBITDA decline
• Very safe for lender
Option B - Moderate: Set at 5.00x
• Base case headroom: 28% (5.00 - 3.92 = 1.08)
• Could withstand 15% decline (downside scenario)
• Balanced approach
Option C - Aggressive: Set at 5.50x
• Base case headroom: 40% (5.50 - 3.92 = 1.58)
• Maximum operational flexibility
• Higher lender risk
| Period | Total Leverage Covenant | Rationale |
|---|---|---|
| Q4 2024 - Q4 2025 | ≤ 5.25x | Initial period - extra cushion for integration |
| Q1 2026 - Q4 2026 | ≤ 5.00x | Year 2 - expect deleveraging |
| Q1 2027 - Q4 2027 | ≤ 4.75x | Year 3 - continued improvement |
| Q1 2028 onwards | ≤ 4.50x | Long-term target |
Total Leverage Covenant: ≤ 5.25x (Year 1), stepping down to ≤ 4.50x (Year 4+)
Senior Leverage Covenant: ≤ 4.00x (Year 1), stepping down to ≤ 3.50x
Interest Coverage: ≥ 2.50x (all periods)
Minimum EBITDA: ≥ $35M (floor protection)
Headroom Analysis:
• Base case projects 3.92x vs 5.25x limit = 1.33x cushion (34%)
• Can withstand 20% EBITDA decline before breach
• Comfortable for both borrower and lender
Test different scenarios and see how covenant ratios change in real-time. Adjust the inputs to understand headroom and compliance.
Reduce revenue to $170M (15% decline). Watch leverage increase and coverage ratios deteriorate. Does it breach?
Increase revolver to $35M (drew $15M more). See how both leverage ratios tighten but coverage stays the same.
Increase interest expense to $18M (SOFR +2%). Interest coverage drops significantly while leverage unchanged.
Increase EBITDA margin to 25%. All ratios improve. See how much extra debt capacity this creates.
Let's walk through a full covenant negotiation from first proposal to final terms, showing the back-and-forth between lender and borrower.
| Period | Revenue | EBITDA | Growth | Margin |
|---|---|---|---|---|
| Q4 2024 (Close) | $180M | $24.0M | — | 13.3% |
| 2025 Projection | $198M | $28.5M | +10% | 14.4% |
| 2026 Projection | $218M | $33.0M | +10% | 15.1% |
| 2027 Projection | $240M | $38.0M | +10% | 15.8% |
Total Leverage: ≤ 4.50x (Year 1) → ≤ 3.50x (Year 4+)
Senior Leverage: ≤ 3.50x (Year 1) → ≤ 2.75x (Year 4+)
Interest Coverage: ≥ 3.00x (all periods)
Fixed Charge Coverage: ≥ 1.30x (all periods)
Minimum EBITDA: ≥ $22M (all periods)
Issue: Seasonal business. Q1 is weakest quarter historically.
Q1 2025 Projection (worst quarter):
• Revenue drops 20% seasonally
• EBITDA: $22M (TTM basis)
• Add-backs limited to $1M (no transaction costs after Q4 2024)
• Adjusted EBITDA: $23M
• Working capital build requires $10M revolver draw
Covenant Test in Q1 2025:
• Total Debt: $90M (drew revolver)
• Total Leverage: $90M ÷ $23M = 3.91x vs ≤ 4.50x
• Headroom: Only 0.59x (15%) → TOO TIGHT!
• Interest Coverage: $23M ÷ $8M = 2.88x vs ≥ 3.00x → BREACH!
"Your covenant levels don't account for our seasonal working capital needs. In Q1, we need to build inventory for Q2-Q3 demand. Here's what works:"
Counterproposal:
Total Leverage: ≤ 5.25x (Year 1) → ≤ 4.00x (Year 3+)
Senior Leverage: ≤ 4.00x (Year 1) → ≤ 3.25x (Year 3+)
Interest Coverage: ≥ 2.25x (all periods)
Fixed Charge Coverage: ≥ 1.15x (all periods)
Minimum EBITDA: ≥ $20M (testing on adjusted basis)
"Your proposal gives you too much cushion at closing (63% headroom) and we're uncomfortable with interest coverage dropping below 2.5x. We need more protection."
Final Covenant Package:
Total Leverage:
• Year 1 (2025): ≤ 5.00x
• Year 2 (2026): ≤ 4.50x
• Year 3+ (2027+): ≤ 4.00x
Senior Leverage:
• Year 1 (2025): ≤ 3.75x
• Year 2 (2026): ≤ 3.50x
• Year 3+ (2027+): ≤ 3.00x
Interest Coverage:
• ≥ 2.50x (all periods)
BUT with quarterly testing flexibility:
→ If only Q1 or Q2 breach by <15%, no default if cured by Q3
Fixed Charge Coverage:
• ≥ 1.20x (all periods)
Minimum EBITDA:
• ≥ $20M (using adjusted EBITDA definition)
Special Provision - Seasonal Waiver:
• In Q1 and Q2 only: Interest coverage can drop to 2.25x without breach, provided it's back to ≥2.50x by Q3 test
| Party | Gets Protection On... | Gives Flexibility On... |
|---|---|---|
| Lender | • Step-downs force deleveraging over time • Multiple covenant types protect from different risks • Minimum EBITDA floor prevents severe deterioration • Still gets early warning if business struggles |
• Higher Year 1 limits accommodate seasonality • Seasonal waiver recognizes business model • Reasonable headroom (25-30%) not excessive |
| Borrower | • Can operate through seasonal cycles • Sufficient cushion for unexpected events • Seasonal waiver prevents technical breaches • Gradual step-downs are achievable with growth plan |
• Commits to deleveraging over 3 years • Accepts tighter covenants in years 2-3 • Must maintain minimum performance levels • Limited operational flexibility if EBITDA drops |
Always identify the worst quarter (seasonally or cyclically) and ensure covenants work there, not just at closing.
Industry standard. Too little = risky. Too much = lender won't accept (you're overequitizing).
Borrowers get flexibility upfront, lenders get tightening over time as business stabilizes and debt pays down.
For businesses with predictable seasonal patterns, lenders will often grant temporary relief if performance recovers quickly.
Don't just focus on one ratio. Coverage and leverage covenants protect different things - negotiate both carefully.
The $6M in EBITDA add-backs (synergies, transaction costs) made the difference between passing and failing covenants.