How much debt can my business carry?

Two tests, one answer

A lender sizing a loan to an established business is asking two different questions. The first is whether the business can make the payments. That is the debt service coverage ratio: cash flow available to pay debt, divided by the principal and interest due in a year. The second is how much debt the business can hold against its earnings, measured as total debt divided by EBITDA. Coverage is about this year's cash. Leverage is about what happens if the business has a bad stretch and the loan has to be repaid, refinanced or recovered from a sale of the company.

The two tests guard against different risks, so lenders run both and lend the smaller result. A business with a long, cheap loan can pass coverage easily and still be over-levered. A business with modest debt can fail coverage if the loan amortizes quickly. Neither test alone tells you your number.

Your debt capacity is the lower of what coverage allows and what leverage allows, less the debt you already carry.

The coverage test, worked through

Start with the cash flow a lender will count. That is usually EBITDA, adjusted for the add-backs the lender accepts, less cash taxes, less the capital spending the business has to keep making to stand still, and less any distributions the owners cannot skip, such as tax distributions from a pass-through company. Lenders that test fixed charge coverage start from the same cash flow and count rent, lease payments and capital spending alongside debt service, so a business that leases its plant and equipment is tested on everything it must pay.

Suppose that cash flow is 1,250 a year. At the 1.25x that conventional bank lenders commonly look for, the business can support annual debt service of up to 1,000. That 1,000 has to cover every loan: the new one, any equipment notes, finance leases, an existing term loan that stays in place, and a seller note that is paying. How much principal 1,000 a year supports then depends on the interest rate and on how fast the loan amortizes. The same payment carries more principal on a slower schedule, which is why an interest-only period or light amortization can raise the coverage answer without the business earning a dollar more.

Two details catch owners out. Lenders test coverage on history, usually the latest full fiscal year and the trailing twelve months, not on next year's budget. And the ratio a lender uses to size the loan is not the ratio written into the credit agreement. The covenant is tested every quarter for the life of the loan, usually with some room below the sizing case; a company sized to the limit on day one has little room for a soft quarter. Covenant headroom is worth negotiating as hard as the amount.

The leverage test, worked through

Take a business with EBITDA of 1,000 after the add-backs a lender accepts. At 2x, senior debt would be 2,000. At 3.5x it would be 3,500. That range is where senior cash-flow lenders to lower-middle-market companies commonly land. Where a particular business lands inside it depends on what the lender thinks its earnings would look like in a bad year.

• Size of EBITDA. Larger earnings are harder to lose to one bad contract or one departed employee, so larger companies tend to sit higher in the range.
• Recurring revenue. Service agreements, subscriptions and contracted work earn more leverage than project or one-off transactional revenue.
• Customer concentration. A customer that could leave with a large share of profit pulls the multiple down.
• Cyclicality and margin history. Lenders look at how far earnings fell in the last downturn, not how high they rose in the last upturn.
• Capital intensity. A business that must reinvest heavily has less cash to repay debt than its EBITDA suggests.
• Management depth. Earnings that depend on one person carry more risk than earnings a team produces.

Senior leverage is not the ceiling on total debt. Unitranche lenders stretch further than senior lenders in a single loan, and mezzanine debt, a second-lien loan or seller paper can sit behind a senior loan. Credit agreements often carry two limits for that reason, one on senior debt and one on the whole stack; senior vs total leverage explains how they interact. Each layer above senior costs more, and the whole stack still has to pass coverage.

Running both tests on one business

The table runs both tests on the same illustrative business: EBITDA of 1,500 after accepted add-backs, cash flow available for debt service of 1,250 after taxes and required capital spending, and existing debt of 1,000 with annual payments of 300.

Which column binds depends as much on the loan's terms as on the business.

How add-backs change the answer

Add-backs move both tests at once, and the leverage test multiplies them. With senior leverage of 2x to 3.5x, every 100 of add-back a lender accepts adds between 200 and 350 of debt capacity, and every 100 it rejects takes the same amount away. That is why the largest disagreement in most files is not the rate or the multiple but the EBITDA the multiple is applied to.

Lenders credit add-backs they can verify and that will not recur: a one-time legal settlement, a documented relocation, an owner's salary above what a hired manager would cost, personal expenses run through the business. They discount add-backs that are really forecasts: savings not yet made, costs of a customer already lost, synergies with a company not yet owned, or a one-time expense that appears every year. The EBITDA add-backs page sets out which is which. An add-back with an invoice, a contract or a payroll record behind it is worth something. One without is worth little.

What counts against the capacity you have

Debt capacity is a total, and lenders count everything that takes cash out ahead of them.

• Existing term debt, equipment notes and finance leases count in full, in both tests, unless the new loan repays them.
• Drawn lines of credit usually count toward leverage, and an existing line's own covenants may limit new debt.
• Seller notes count in coverage if they pay, and usually count toward total leverage even when they are subordinated. Whether a note is excluded from the senior test is a point to settle in the term sheet, not after closing; see seller note terms in conventional deals.
• Shareholder loans are usually subordinated and left out of the tests, but only if the owners agree not to be repaid ahead of the lender; see shareholder loans and lenders.
• Rent and leases sit inside fixed charge coverage and, for some lenders, inside an adjusted leverage figure.

What raises the number, and what does not

Some levers change what a lender will offer. Lighter amortization raises the coverage answer. Real estate can be financed on its own terms, with a mortgage, a separate property company or a sale-leaseback, which takes pressure off the operating loan, though a sale-leaseback adds rent that fixed charge coverage will count. A company with large receivables and inventory may borrow more in total by pairing an asset-based line with a smaller term loan. A current set of figures, with a year-to-date P&L through last month-end, lets the lender size on today's earnings rather than last year's. More equity does not raise what the business can carry, but it reduces the loan needed and improves how a lender reads the whole structure.

Other things do not move it. Projections alone rarely increase a loan, because lenders size on what the business has earned; a delayed-draw facility is the usual way to have debt ready for growth that has not yet happened. Revenue growth without margin growth does not help the leverage test. And a business worth far more than its debt still has to pay that debt from cash flow; value is the lender's second way out, not its first. How lenders value a business covers that second test.

How Midas Partners sizes it before a lender does

Before a file goes to market, Midas Partners's underwriting runs both tests on the figures a lender will see: EBITDA with each add-back documented or dropped, every existing obligation from the debt schedule, and the proposed loan at realistic terms. Senior bankers run every engagement; software does the analyst work and a senior banker checks every page before the client approves it. Once a borrower's documents are in, the full lender package — financing model, lender presentation, blind teaser and underwriting memo — is built in a day. Built by hand, the same package takes at least a week.

The model shows coverage and leverage for each structure considered, so the number you take to lenders is one they can reproduce. Midas Partners's book holds 1,800+ lenders; 1,148 write term and private credit and 235 write asset-based lending and lines. That range matters, because the lender whose own sizing method fits your business is the one likely to offer the most sensible amount. Lenders that fit see a blind teaser first, and you approve each one by name before it learns who you are.