Headroom Before the Handshake: A Covenant Rehearsal for Year-End Numbers

Most owner-managers first see their covenant position when the compliance certificate is ready for signature. By then, the numbers are historical, the auditor has formed a view, and the lender's credit team is working from a completed set rather than a forecast. The result is a conversation conducted at the wrong end of the calendar, when the only remaining options are explanation and cure.

A covenant rehearsal moves that conversation forward. Using draft November management accounts and a realistic December forecast, an owner-manager can rebuild the lender's ratios on the lender's own definitions and see the year-end position while there is still time to act. The objective is not to engineer a favourable number. It is to understand the headroom, test the sensitivities, and approach the bank with a prepared position rather than a surprise.

The definitions govern the calculation

Facility agreements rarely use the same EBITDA that appears in a management pack. Before any modelling begins, extract the definitions of EBITDA, Net Debt, Finance Charges, Relevant Period and Testing Date from the agreement, together with the schedule of financial covenants and any add-back caps. Pay particular attention to whether the test is measured on a rolling twelve-month basis, whether it is tested quarterly or annually, and whether the lender permits pro forma adjustments for acquisitions or disposals.

Two practical points are often missed. First, many agreements freeze accounting policies at the date of signing, so a change in revenue recognition or lease treatment under FRS 102 can alter the covenant calculation even where the commercial position is unchanged. Second, add-backs are usually capped, either as a percentage of EBITDA or as a fixed cash amount. A rehearsal that assumes every exceptional cost is added back will flatter the position and undermine credibility when the certificate is reviewed.

The tests that matter for most SMEs

Three covenants appear repeatedly in UK SME facilities. Leverage compares Net Debt to EBITDA, sometimes on a senior basis and sometimes after permitting a defined cash balance to be netted against borrowings. Interest cover divides EBITDA by net finance charges, and it is sensitive to both the base rate and the margin on the facility. A minimum EBITDA or minimum tangible net worth test sets a floor rather than a ratio, and it can be breached by a single bad debt or a delayed contract even where leverage looks comfortable.

Asset finance and hire purchase arrangements often carry separate tests, including loan-to-value thresholds and payment cover ratios. Where a business holds an invoice finance facility, the relevant covenant may be a dilution or concentration limit rather than a traditional accounting ratio. A rehearsal should map every facility, including any overdraft, to its own test so that a cross-default risk is visible.

Build a one-page model from the draft accounts

The most useful rehearsal fits on a single page. Start with the draft management accounts for the eleven months to 30 November 2026 and add a December forecast built from known orders, committed costs and a realistic collection profile. Recalculate EBITDA line by line against the facility definition rather than taking the accountant's adjusted figure as given. Then compute Net Debt at the testing date, remembering that cash may be restricted, that an overdraft is usually borrowings, and that asset finance balances are included even where they are secured elsewhere.

Run the calculation month by month across the rolling period. A year-end test can be distorted by a strong January or a weak November that falls outside the measurement window, and the monthly view exposes that distortion. It also shows whether headroom is improving or narrowing as the year closes, which is the more persuasive point in any conversation with a lender.

Where the arithmetic tends to move

Several timing issues routinely turn a comfortable year into a thin one. Revenue cut-off is the most common: an invoice raised in January for December work will not appear in the year-end accounts unless the agreement is clear on delivery. A credit note issued after the year-end, a customer failure in the final fortnight, or a stock provision identified during the audit can each reduce EBITDA after the certificate has been drafted.

On the debt side, a director's loan repayment, a dividend declared before the year-end, or an asset purchase funded from cash rather than finance will increase Net Debt at the testing date. So will the mark-to-market movement on an interest rate swap where the agreement includes it in borrowings. Lease classification, grant income recognition and research and development credits can all shift the result, and each should be tested explicitly rather than assumed to be neutral.

Three scenarios and a list of levers

A credible rehearsal presents a base case, a downside case and a management-action case. The downside might assume a ten per cent fall in EBITDA, a delayed customer payment or a fifty basis point rise in finance costs. The management-action case should contain only steps the board can realistically deliver before the testing date: deferring discretionary capital expenditure, accelerating debtor collection, reducing stock, delaying non-essential recruitment, or disposing of a surplus asset where the net proceeds are treated as expected under the facility.

Equity injections and equity cure rights deserve early attention. Some agreements permit a shareholder injection to be treated as EBITDA for covenant purposes, but usually only once or twice during the life of the facility and within a defined period after the testing date. The cost and the dilution should be understood well before December, not discovered in February.

The conversation with the lender

Where the rehearsal shows thin or negative headroom, the relationship manager should hear it from the business first. A short pack containing the draft numbers, the covenant calculation, the forecast and the proposed remedy is far more useful than a call after the certificate is due. Ask about the lender's own testing timetable, whether a waiver or amendment is available, and what fees or conditions would apply. Record the board's consideration in the minutes.

What the lender will not accept is a set of calculations that departs from the agreement without explanation. Aggressive add-backs, reclassified debt or a cash balance netted where the agreement does not permit it will damage credibility and may amount to a misrepresentation. If the position is genuinely stressed, take advice on the directors' duties and on the options available before the year-end rather than after it.

A short rehearsal checklist

• Extract every financial covenant and definition from each facility agreement, including asset finance and invoice finance.
• Rebuild EBITDA from the draft management accounts using the lender's definition and add-back caps.
• Calculate Net Debt at the testing date, including overdrafts, HP balances and restricted cash.
• Model the rolling period month by month and test base, downside and management-action cases.
• Identify the three levers that can be delivered before 31 December 2026 and quantify each one.
• Speak to the relationship manager before the certificate is due, and minute the board's decision.

The year-end will arrive whether or not the arithmetic has been rehearsed. The difference is whether the business meets it with a prepared position or with a set of numbers it has not yet tested.