assess your company debt capacity

7/31/2019 Assess Your Company Debt Capacity

1/31 www.lanternadvisors.com

Assess Your Co mpanys Debt C apacity Using This Financial Rule of ThumbBy Chris Risey, Lantern Capital Advisors

If you are interested to renance your companys debtor get additional capital, there is a fairl y simple rule ofthumb that can help you quickly gauge your nancingalternatives and make sense of todays lendingenvironment.

We all know rules of thumb arent gospel but they canprovide insight into possible solutions. The rule ofthumb for nancing is to look at a companys debt

compared to its EBITDA (or Earnings Before InterestTaxes Depreciation and Amortization). Established,protable companies have historically been able toborrow up to about 4 times (X) EBITDA.

Using a simple example, a company that generatesannual EBITDA of $2 million should have a debtnancing capacity of about $8 million assuming aDebt Multiple of 4(X) times. So, if, for example, thecompany had $5 million of existing debt, it would haveadded debt capacity of about $3 million. [See Figure1.]

[Figure 1]

While the formula is simple, applying it to real lifesituations, often requires a closer look at each of themajor components: EBITDA, Debt and the DebtMultiple.

EBITDA (with some adjustments)

Financial institutions typically look at last yearsEBITDA or EBITDA over the last 12 months. EBITDA issupposed to approximate a companys underlying

If you are interested torenance your companysdebt or get additionalcapital, there is a fairlysimple nancial rule ofthumb that can help youquickly gauge yournancing alternatives andmake sense of todayslending environment.

WHITE PAPER

N o v e m

b e r

2 0 1 0

EBITDA $2,000,000Debt Multip le 4XFinancing apacity $8,000,000

Less: Existi ng Company De t ($5,000,000)

Additional ebt Capacity $3,000,000
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cash ows generated by the business and normalizesthe impact of nancing, taxes and n on-cash expensessuch as depreciation and amortization . That said, forcompanies with signicant capital assets, such asmanufacturing businesses, on-going capital expendituresshould be deducted from EBITDA in order to account forthe expense of maintaining the operating assets.

Also depending on the situation, adjustments to EBITDA can be made for signicant and non-recurring revenue orexpenses. Examples of adjustments could include one-time litigation expenses, moving expenses, discretionarybonuses, or the gain (or loss) on the sale of a building.Probably the most interesting adjustment weve madewas for a $750,000 customer appreciation party!

What are we calling debt?

Debt obviously includes bank debt but it can also includedebt from a variety of non-bank lenders such ascommercial nance companies, mezzanine lenders,subordinated debt providers, operating companies,business development corporations, and insurance funds

to name a few.Most companies have limited knowledge of non-banknancing sources but they actually outnumber large banklenders. In round numbers, there are about 175 banks thathave assets of $5 billion or more. In comparison, we haveidentied over 500 non-bank lending groups, or roughly 3times the number of large banks.

Equally interesting, unlike traditional banks these groupsare actively lending. As a general rule, non-bank lenderstend to charge higher rates than traditional banks but theyalso typically offer more capital. Non-banks may alsoprovide nancing with less restrictive covenants, such aslimited personal guarantees, thus lowering the ownersrisk when compared to traditional banks.

The Moving Debt Multiple

While we have be en discussing the debt multiple basedon its historical average over the last 10 years, its doesuctuate (which is why this a rule of thumb) [see gure 2].In our currently poor economy, banks (and some non-banks) are hurting. That hurt is reected in the averagedebt levels on new nancings. In 2009 and early 2010average debt multiples for new nancings were below 3(X)times. Today, we are seeing debt multiples still around 3Xbut starting to creep up to 3.5X for businesses withpredictable future revenue. [Figure 2 is a chart thatsummarizes the average debt multiples over the last 10years.]

Where are we today?

Looking at the chart below helps better explain todayslending problems. The media likes to paint a simplepicture that banks have pulled back but that is only halfthe story. In our bad economy, many businesses areexperiencing declining EBITDA and increasing debt levels.This combination creates a quick no mans land scenario

where the existing lender pulls back and no other lender isinterested to take their place. Heres a simple illustrationusing our earlier example [from Figure 1].

2 years ago Today

EBTIDA $2,000,000 (Decline) $1,500,000Debt Multiple 4X (Decline) 3XFinancingCapacity $8,000,000 $4,500,000

Less: ExistingCompany Debt

($5,000,000 ) (Increase)($6,000,000)

Additional DebtCapacity(Decit) $3,000,000 ($1,500,000)

ASSESSYOURCOMPANYSDEBTCAPACITYWHITE P A P E R L I B R A R Y

NOVEMBER2010

[Figure 2] Historical Debt to EBITDA Multiples
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This example illustrates how lenders are lending less (whichis reected in the lower current Debt Mu ltiple) but also howa companys current performance can contribute to theproblem.

Other Exceptions

All this being said, the nancing multiple is still not a tell-allindicator. Some companies with signicant collateral orassets are often able to borrow larger amounts than theaverage multiple implies because the bank is comfortablewith the collateral (such as accounts receivable andinventory) or the debt on the asset can be repaid over along period of time (such as a mortgage on a building). Thiscreates more room for free cash ow to service debt.

Ultimately a companys nancing capacity is driven by thecurrent economic climate and interest level of prospectivelenders or investors. The more a lender falls in love with a

company, the m ore aggressive they will be. Conversely,the more skittish they are of the company (or industry), theless nancing they are willing to give. Equally interesting,these opinions (and multiples) can vary betweeninstitutions, which is why its good to shop numerousnancing sources.

Still, knowing this simple rule of thumb can help CEOs andowners quickly assess their nancing options so they caneither explore it further or get back to the business ofbuilding value, which means nding ways to increaseEBITDA, lower debt, or do both!

ABOUT THE AUTHORChris Risey is the founder and president of Lantern Capital Advisors, an Atlant abased corporate nancial consulting rmthat helps entrepreneurial companies nance growth, acquisitions and buyouts in a way that best suits their companysunique needs and growth potential.

Mr. Risey is a frequent writer and speaker to nancial executives and entrepreneurs through out the country interested tolearn more about corporate nancial planning and how to use it to build greater value in todays nancial markets. Mr.Risey began his career as a CPA with Arthur Andersen. Mr. Risey is a magna cum laude graduate of the University ofSouth Florida. He was twice named Academic All-American (Men Basketball) and is a former Rotary International

Ambassadorial Scholar.

CONTACT LANTERN CAPITAL ADVISORS

To learn more about Lantern Capital Advisors and assessing your companys debt capacity, please visit our websitewww.lanternadvisors.com or contact us directly at 678 385 5937.

Knowing this simple rule of thumb can help CEOs andowners quickly assess their nancing op tions so theycan either explore it further, or get back to the businessof building value, which means nding ways toincrease EBITDA, lower debt, or d o both.

ASSESSYOURCOMPANYSDEBTCAPACITYWHITE P A P E R L I B R A R

YOCTOBER2010
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