From Cash Flow Available for Debt Service to Debt Capacity

Ask an owner how much the business could borrow, and the answer is usually a multiple: the bank said three times EBITDA, or four. Ask a credit committee and the answer is a downside. The committee wants to know how much debt the business can carry in the year that goes wrong, because that is the year in which a lender loses money, and the year everyone expects tells it very little.

The second span of the fourth bridge answers the committee's question with the business's own evidence. It starts from cash flow available for debt service, the lender's figure, reported monthly and reconciled. It ends at debt capacity: a coverage ratio and a leverage ratio a lender will put on a term sheet, sized to a downside the business set itself, with its growth still funded.

What the measure is

Debt capacity is the largest debt the business's cash flow can carry while meeting two tests a lender will apply. The cash available has to cover the interest and principal due with room to spare, which is the coverage ratio, and total debt must not be too large a multiple of earnings, which is leverage.

It comes second on the bridge because it is computed from the first span's measure, and a lender cannot size a facility on a figure it does not trust. It comes before the facility is drawn because a business that borrows before it knows its capacity borrows whatever it is offered.

The three drivers

Levered Forecast shows how much debt the cash flow carries in a downside. A thirty-six-month forecast, built on the enterprise forecast inspected at the start of the bridge, shows levered cash flow and every covenant test month by month, in a base case and in a downside with revenue well below base and interest rates higher than the market expects. The downside is written down and approved before the model is run, so nobody can tune it to pass. A year of forecast against actual shows the forecast can be trusted, and a rate stress with a written policy limits how far interest rates can move the cash flow before any debt is drawn.

Facility Sizing turns that computed ratio into a term sheet. The facility is sized from the downside, keeping coverage at or above the floor and leverage below a ceiling, with headroom to every covenant. It is structured so that no single year carries too much of the debt's maturity, and it is tested with more than one lender, each compared on covenants, security, guarantees and prepayment terms as well as rate.

Growth Capacity changes what debt capacity means. It becomes the largest debt the cash flow can carry while still funding its own growth. The reinvestment plan sits in the levered forecast as its own line, below debt service. The loan agreement carries allowances, called baskets, that let the plan go ahead without asking the lender, and an undrawn line covers the gap the downside opens. After that, the register shows year after year whether growth continued under the debt.

Sizing from the downside

Once the downside exists, the arithmetic of sizing is simple, and it usually surprises owners who have only heard multiples.

Downside cash flow available for debt service, less the headroom the facility keeps in a bad year, divided by the coverage floor, is the annual debt service the business can afford. Divide that by what each dollar of debt costs each year in interest and repayment, and you have the debt the downside supports. That figure is checked against the leverage ceiling, and the smaller answer wins. In the illustration, a business with $950,000 of cash available in its base case and $870,000 in its downside, keeping 10 percent headroom in the downside and borrowing at 8 percent over seven years, can carry $2.8 million. Sized on the base case, it would have been offered about $3.1 million. A multiple of three times its $1.4 million of adjusted EBITDA would have suggested $4.2 million.

The gap between $2.8 million and $4.2 million separates debt that survives a bad year from debt that turns a bad year into a default. A business that knows the first number can choose to borrow it, and explain why, when a lender offers the second.

Growth inside the structure

The third driver is what sets this span apart from ordinary credit analysis, and it is the most valuable driver on the bridge.

A facility sized to a cash flow that assumes no growth spending leaves growth exposed. In the first soft quarter, growth spending is the easiest line to cut, because it is discretionary, nobody is owed it, and cutting it protects the covenant. The business stops growing on the day it borrows, the equity buyer prices it as a business that has stopped growing, and the growth value the reinvestment register earned on the third bridge is lost to the structure. Growth Capacity puts the plan inside the structure: the downside shows how much of it retained cash can fund, the largest shortfall sets the undrawn line, the baskets are sized to the plan and agreed on the term sheet before signing, and once the facility closes, any deferral of a growth project is a board decision with a written reason.

What it does to value

Each driver does something different to value.

Growth Capacity ranks first on the bridge, because it is the only driver here that moves growth. The reinvestment the structure lets the plan keep in a soft quarter earns the spread of its return over the cost of capital for every year of the advantage period, and that spread compounds.

Facility Sizing ranks third. It fixes the size of the tax shield the bridge will ever earn, the tax saved on the interest of the facility actually obtained, which is counted once for the whole bridge on this driver, less the expected cost of a breach at the headroom obtained. The basis points a second term sheet takes off the margin are price.

Levered Forecast ranks fourth. It sizes the tax shield without earning it. Its own value is the fall in the probability of a breach that comes from a facility sized to a downside instead of the base case. If a committee offers a larger facility because the record has earned its trust, that is price too.

How the drivers depend on each other

The drivers are built in order, each on the one before. The forecast needs the budget accuracy inspected at the start of the bridge, because a levered forecast built on budgets that missed inherits the miss, and it needs the lender's figure reconciled under Lender Reporting, because the forecast and the pack must use the same definition. The sizing needs the forecast's downside, since without it the facility is sized to the base case. It needs the capital structure file, because lenders size on total obligations and a debt-like item found after the term sheet reopens it. And it needs a record of on-time lender packs, because lenders price history.

Growth Capacity needs all of that. The reinvestment register inspected at the start of the bridge is the plan it protects. The downside case is where the funding gap, the drawing conditions and the basket sizes are read from. Competing term sheets matter because baskets are negotiated, and negotiation needs more than one lender. And counsel has to be briefed on the plan before reading the lender's draft.

How the span comes undone

The span can come undone in five ways. Leverage creeps past capacity as small borrowings add up. A covenant is breached. A maturity arrives with no committed refinancing. Growth spending becomes the first line cut to protect a covenant. Or the protections for growth wear away, when the undrawn line lapses or is drawn for something other than growth, or a basket is amended down at renewal in exchange for a lower rate.

The defences are mostly early warning. A rolling forecast always shows a year of covenant headroom, refreshed by a quarterly reforecast on a fixed date, so a squeeze appears a year before it arrives. A written leverage ceiling sits below every covenant, so new borrowing hits the company's own policy first. Refinancing starts well before any maturity, on a date set when the facility is signed. Reinvestment against plan is a standing page in the lender and board packs, the growth line's expiry sits on the maturity ladder, and any draw for another purpose needs a board minute. At every renewal, basket size is compared beside price, so a lender offering a lower rate for a smaller basket is scored, not simply accepted.

Crossing the span

The span is crossed when a lender has issued, or would issue, a term sheet on the business's own cash flow, sized against a downside and not the base case, with the reinvestment plan funded inside that structure instead of cut to fit it. The next span puts the debt in place and keeps it there.