How do you decide how much debt a company can support?
Start with how stable cash flow is, then test leverage and interest coverage after capex. With $100 million EBITDA, $20 million capex and 8% interest, 5x debt costs $40 million a year. A 30% EBITDA drop leaves $50 million, only 1.25x coverage, so choose 4x.
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Example answer
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I'd look at the company's cash flow and at its leverage. The first question is how stable the cash flow is. Then I'd test it with two kinds of ratio. One is leverage, meaning debt to EBITDA, which says how big the debt is against earnings. The other is coverage, like EBITDA to interest, which says whether the company can pay for it. I'd compare those with similar companies and with what lenders usually allow. A stable company can take on more debt and a cyclical one can take less.
What holds it back
The right ratios are named, and stability is mentioned. But there's no downside case and no numbers, so it never shows how you'd get from a ratio to an amount of debt.
Debt capacity is the amount of debt the company can service in a bad year, not in an average one. The first question is how stable the cash flow is. Then I'd test it with two kinds of ratio. One is leverage, meaning debt to EBITDA, which says how big the debt is against earnings. The other is coverage, like EBITDA to interest, or EBITDA minus capex to interest, which says whether the company can pay for it. Take a company with $100 million of EBITDA and $20 million of capex, and assume debt costs 8%. At 5 times EBITDA, debt is $500 million and interest is $40 million. EBITDA covers interest 2.5 times, and after capex it's 2 times. Now run a downside where EBITDA falls 30% to $70 million. Debt is over 7 times EBITDA, and EBITDA minus capex is $50 million against $40 million of interest, so only 1.25 times. That leaves $10 million for taxes, working capital and repayments, which is too thin. At 4 times, debt is $400 million and interest is $32 million. In the same downside, $50 million covers interest about 1.6 times and leaves $18 million. So I'd be comfortable around 4 times and not at 5.
Debt capacity is the amount of debt the company can service in a bad year, not in an average one. The first question is how stable the cash flow is: how recurring the revenue is, how cyclical the industry is, and how much capital expenditure the business needs. Then I'd test it with two kinds of ratio. One is leverage, meaning debt to EBITDA, which says how big the debt is against earnings. The other is coverage, like EBITDA to interest, or EBITDA minus capex to interest, which says whether the company can pay for it. Take a company with $100 million of EBITDA and $20 million of capex, and assume debt costs 8%. At 5 times EBITDA, debt is $500 million and interest is $40 million. EBITDA covers interest 2.5 times, and after capex it's 2 times. Now run a downside where EBITDA falls 30% to $70 million. Debt is over 7 times EBITDA, and EBITDA minus capex is $50 million against $40 million of interest, so only 1.25 times. That leaves $10 million for taxes, working capital and repayments, which is too thin. At 4 times, debt is $400 million and interest is $32 million. In the same downside, $50 million covers interest about 1.6 times and leaves $18 million. So I'd be comfortable around 4 times and not at 5. Then I'd check that against two outside tests. One is what lenders have accepted for similar companies. The other is the loan terms. The company has to stay inside its covenants in the downside, and it has to be able to refinance what's left at maturity. The answer also changes with the business. A subscription software company with low capex can carry more turns of debt than a cyclical manufacturer with the same EBITDA. And the right amount is below the maximum, because the owner wants room to invest and to absorb a surprise.
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The numbers, step by step
A company with $100 million of EBITDA and $20 million of capex, debt at an assumed 8% interest rate, and a downside where EBITDA falls 30%. Figures in $ millions.
- Debt at 5 times EBITDA$100 × 5
- $500 million
- Interest at 8%$500 × 8%
- $40 million
- EBITDA to interest$100 / $40
- 2.5x
- EBITDA minus capex to interest($100 − $20) / $40
- 2.0x
- Downside EBITDA$100 × (1 − 30%)
- $70 million
- Downside debt to EBITDA at 5 times$500 / $70
- about 7.1x
- Downside coverage after capex at 5 times($70 − $20) / $40
- 1.25x
- Downside coverage after capex at 4 times($70 − $20) / ($400 × 8%)
- 1.56x, about 1.6x
- Downside cash left at 4 times$70 − $20 − $32
- $18 million
What the interviewer listens for
- Do you start from cash flow and its stability, not from a rule of thumb?
- Do you use both a leverage ratio and a coverage ratio?
- Do you run a downside case and not only the base case?
- Do you land on an actual amount and say why?
Common mistakes
- Quoting a single leverage multiple as the answer for every company.The same multiple can be safe for a subscription business and too much for a cyclical one.
- Testing only the base case.Debt is fixed while earnings move, so the question is whether interest is still covered when EBITDA drops.
- Using EBITDA to interest alone for a business with heavy capex.Maintenance capex has to be spent to keep the business running, so subtract it before measuring how much is left for interest.
- Treating the most that lenders will offer as the right amount.The owner also needs cash for investment and for a year that goes wrong.
More finance technicals
- Walk me through a basic LBO.
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- Why private equity?
- What is the difference between IRR and MOIC?
- Where do the returns in an LBO come from?
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