Investment banking (iv) - debt capacity analysis

"Debt capacity" here refers to the maximum amount of debt that a company can support. 

Evaluating debt capacity is an important task done by investment bankers, because it helps to optimize a company's capital structure, giving the company an appropriate amount of debt funding to conduct / expand its business

Determining the debt capacity of a company is not a rocket science; it involves a lot of subjective thinking. However, there are several metrics that serve as guides for investment bankers.   

Leverage ratios 

Leverage ratio tells us a company's debt is how many times of its cashflow. There are two types of leverage ratios:

1. Gross leverage: (total debt / LTM EBITDA). Gross leverages evaluates the size of a company debt relative to its last-twevle-months EBITDA (note: it is a prevalent practice among bankers to use LTM EBITDA as a proxy for cashflow). 

For example, if a company has a gross leverage ratio of 4.0x; the implication for bankers is that it will take the company approximately 4 years time pay down its debt using cashflow generated by the company. 

2. Net leverage: (total debt - cash) / LTM EBITDA. Net leverage is slightly different from gross leverage by focusing on a company's net debt (ie. a company's total debt net of cash.)

Illustrative example: company ABC

• LTM EBITDA = USD 50mn
• Total debt = USD 75mn
• Cash = USD 25mn 

Gross leverage = 75 / 50 = 1.50x

Net leverage = (75 - 25) / 50 = 1.00x

Now, if I, an investment banker, comes in and says that we are comfortable with leveraging a company up to 3.00x gross leverage. That means we think the company can support total debt of USD 150mn (USD 50mn *3). Hence, we will lend an additional USD 75mn (USD 150mn - USD 75mn) to leverage the company.

That's how leverage ratios works in a nutshell.

For any questions / feedback, you are most welcome to post a comment. I hope this blog will be a platform for us to exchange ideas and learn from each other.