Modeling Debt Capacity Analysis

Modeling Debt Capacity Analysis

When To Use

• Sizing a new term loan, revolver, or bond issuance for a corporate or sponsor-backed borrower
• Evaluating how much incremental leverage a borrower can support for an acquisition or recapitalization
• Stress-testing an existing capital structure ahead of a refinancing or covenant amendment
• Providing lender-side analysis of maximum supportable debt in a credit approval process
• Comparing debt capacity across capital structure alternatives (senior secured vs. unsecured, fixed vs. floating)

Inputs To Gather

• Historical financials — 3 years minimum of income statement, balance sheet, and cash flow statement
• Management projections — Base-case revenue, EBITDA, and capex forecasts for the projection period (typically 5–7 years)
• Existing debt schedule — All outstanding obligations with maturity dates, interest rates, amortization terms, and covenant packages
• Industry comps — Leverage multiples (Total Debt / EBITDA, Senior Debt / EBITDA) and coverage ratios for comparable credits [VERIFY: confirm peer set and data source recency]
• Applicable credit agreement terms — Permitted indebtedness baskets, restricted payment capacity, EBITDA add-back definitions, and financial maintenance covenants
• Tax rate and NOL schedule — Effective tax rate and any available tax shield carryforwards
• Interest rate assumptions — Current reference rate (SOFR, etc.), applicable credit spread, and floor if any [VERIFY: confirm current benchmark rate]

Workflow

1. Normalize EBITDA

   • Start from reported EBITDA; apply recurring add-backs (stock-based comp, non-recurring restructuring, run-rate synergies with haircut)
   • Reconcile against credit agreement EBITDA definition if an existing facility is in place
   • Flag any add-back exceeding 15–20% of reported EBITDA for scrutiny

2. Calculate free cash flow available for debt service

   • EBITDA less cash taxes, maintenance capex, cash interest, and required working capital investment
   • Exclude growth capex and discretionary items to isolate mandatory cash obligations
   • Derive unlevered free cash flow (pre-interest) and levered free cash flow (post-interest) separately

3. Apply leverage capacity constraints

   • Coverage-based: Set minimum DSCR (typically 1.20–1.50x for investment grade; 1.00–1.20x for leveraged) and solve for maximum debt service, then back into principal
   • Multiple-based: Apply market-clearing leverage multiples (e.g., 4.0–6.0x Total Debt / EBITDA for leveraged credits) to normalized EBITDA [VERIFY: current market leverage multiples for the relevant sector and rating tier]
   • Amortization-based: Model mandatory amortization (typically 1–5% p.a. for term loans) and ensure cash flow covers scheduled principal plus interest
   • Take the minimum of the three approaches as the binding constraint

4. Build the debt capacity waterfall

   • Senior secured tranche: sized first, at lowest leverage multiple (e.g., 3.0–4.0x)
   • Second lien / mezzanine: incremental capacity between senior ceiling and total leverage cap
   • Unsecured or subordinated: residual capacity if total leverage headroom permits
   • Sum tranches to arrive at total debt capacity; compare against equity check and LTV constraints if applicable

5. Stress-test under downside scenarios

   • Revenue decline case: typically –10% to –25% from base, depending on industry cyclicality
   • Margin compression case: EBITDA margin reduction of 200–500 bps
   • Interest rate shock: +200–300 bps on floating-rate tranches
   • Combined stress: revenue decline plus rate increase simultaneously
   • For each scenario, verify that DSCR stays above 1.0x and leverage stays within covenant thresholds through the projection period

6. Sensitivity tables

   • 2-variable tables: debt capacity as a function of (a) EBITDA level vs. leverage multiple, (b) interest rate vs. DSCR floor
   • Highlight breakeven points where covenants would trip or cash flow turns negative

Output

• Debt capacity summary table: Maximum supportable debt by tranche (senior, sub, total) with corresponding leverage multiples and coverage ratios
• Cash flow waterfall: Annual projection showing EBITDA → cash taxes → capex → interest → amortization → free cash flow surplus/deficit
• Covenant compliance matrix: Projected leverage and coverage ratios vs. covenant thresholds across base and stress cases
• Sensitivity grids: Debt capacity under varying EBITDA, rate, and margin assumptions
• Key assumptions register: Documented inputs, sources, and any items marked [VERIFY]

Quality Checks

• Confirm EBITDA adjustments reconcile to audited financials or management bridge — no unexplained gaps
• Verify interest expense is calculated on average debt balances (not period-end) with correct day-count convention
• Ensure amortization schedules sum to stated maturity amounts and cash sweep mechanics are modeled if applicable
• Check that downside stress scenarios produce DSCR below base case — if not, the stress is too mild
• Cross-check leverage multiples against recent comparable transactions and rating agency benchmarks [VERIFY: source and date of comp data]
• Validate that the binding constraint is clearly identified and that no tranche exceeds its individual sizing cap
• Confirm all circular references (interest ↔ debt balance ↔ cash sweep) are resolved via iteration or macro