very simple question. How do you estimate how much debt you can put on a company for acquisition purposes? Why can you put 3.5x senior debt on one transactions and 5x on another? Obv industry and volatility of earnings is gonna play a major role, but mathematically, whats the formula to determining the debt capacity?
Qualitative Debt Capacity Analysis
The amount of debt that a company can obtain depends on a variety of different factors. Some of these factors include:
- Current capital structure and types of debt
- EBITDA and ability to handle interest expense
- Size of the company
- Industry (stable or cyclical)
- Current credit rating
- State of the credit markets
Our users explain below.
Its debt capacity is dynamic and based on a variety of factors including capital structure, type of debt, covenants, etc, but ultimately depended on its ability to handle the interest expense. So FCF = after-tax interest expense.
Things to also take into consideration: size of company and industry (ie stable vs cyclical CF), credit, and more importantly, how much debt the company currently has. In the middle market, it's tough to get more than 5x debt/ebitda, so if the company doesn't have any debt, obviously, you can lever it up more in a lbo/acquisition.
A lot of it also has to do with how much the banks are willing to lend. This comes as a result of many company specific factors, including those that were mentioned in the other posts, but is also dependent on the state of the economy at the time. Deals were a lot more levered pre-crisis than now because banks are not lending as much. When they do lend, they put in place a lot more covenants to prevent excessive leverage.
It's also useful to think of debt capacity in terms of credit rating. Even if the market allows you to take on a lot of debt, the company wouldn't want to be rated at near default (in most cases).
What I mean is, the question is not "What is the maximum debt capacity of this company?", but "What is the maximum debt load required to remain investment grade/above AA/etc".
Quantitative Debt Capacity Calculation
From a quantitative perspective this can be done several ways. However, at sell side firms when doing quick analysis about how much debt a company can take on, banks will look at the Debt / EBITDA multiple. EBITDA is a proxy for cash flow and the ability of a company to pay off its debts and interest expenses with the cash flows from the operations of the business.
Using a Net Debt / EBITDA multiple, a bank can get a quick sense for how much debt a company could take on and still be in line with the average leverage levels of the peer set or industry. You can also use this method to check for covenant compliance if a firm has a covenant that specifies a Debt / EBITDA multiple or if a credit rating agency has promised a downgrade if the company falls below a certain debt / EBTIDA level.
You can see the process below.
The bank looks at the industry average Debt to EBITDA metric and multiplies it by the company's EBITDA to find the total capacity for debt and removes the current debt to find the additional capacity that the company could handle.
A similar approach can be applied using the interest coverage ratio.
While this is a quick method, it is important to note that debt focused groups such as DCM or Leveraged Finance will have more precise ways of deciding how much debt the company can take on.
Read More About Net Debt on WSO
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