Calculating Maximum Debt Capacity

This is a very quick post to just record the formula to calculate maximum debt capacity.  I’m using SDI’s finals from earlier this week to provide example numbers.

In the European market banks will typically include a covenant that requires a company to keep its net debt below a level calculated as L x EBITDA, where “L” is the maximum leverage permitted.  In normal circumstances you should expect L to be circa 2 to 2.5 for a listed corporate.  However, for an acquisitive company it’s possible to negotiate a “leverage spike”, which provides more flexibility on a temporary basis.  This would permit L to spike as high as, say 3, to permit an acquisition provided that it’s brought back down to a normal level within a reasonable period of time (say 18 months).

Last year SDI’s EBITDA was approximately £9m and so, on the face of it, you might assume that the maximum debt that SDI could utilise on a “spike” basis is £9m x 3 = £27m.  However, this doesn’t take into account that an acquisition would be EBITDA additive and hence more debt can be utilised based on this additional EBITDA.

We’ll use the following assumptions to find the maximum amount that a bank would typically lend to SDI:

1. Current Gross debt of approx. £3m
2. Current EBITDA £9m
3. Assume any acquisition is made on a 6 x EBITDA multiple
4. Assume maximum gross debt is 3 x EBITDA including 100% of acquired EBITDA (a bank may sometimes limit this to say 75% or other)

Hence maximum new gross debt = 3 x £9m + New Debt / 6 x 3 – £3m

Rearrange this to get:

New Debt = ( 3 x £9m – £3m ) / ( 1 – 3 / 6 )

and you’ll see that SDI should be able to take on new debt of £48m!  Their existing is RCF is £5m and undrawn! (NB, I’ve glossed over the finer detail here of net debt rather than gross debt.)

Don’t expect SDI to do this though, that would be imprudent and leaves little room for manoeuvre if the business takes a temporary down turn.   However, it does illustrate that agreeing, say a £30m facility, wouldn’t be such a big deal.