Topic 41
Debt Limits
The use of debt in financing a transaction has practical and proscribed limits. Topic 41 explores the general level of constraints placed on borrowers by lenders.
THE PRACTICAL LENDING LIMIT IS UP TO LENDERS
- Theoretically, debt financing that creates interest expense that approaches the level of earnings before interest and tax (EBIT) would surely maximize returns on the equity holder's investment, keeping in mind that operating profit is not affected by leverage and that free cash flow is higher by the amount of taxes not paid due to the interest shield (see Topic 40).
- Practically, however, lenders will lend only up to limits they are comfortable with. The aim of these limits is to avoid the costs of financial distress resulting from economic cyclicality or mismanagement.1
- Lenders’ comfort limits are negotiated by lenders and equity investors as levered deals are put together.
- Typical deal lending limits reflect the following constraints, depending on the business cycle and the resulting business and lending climate. In the early to mid-2000s, lending limits were considerably higher than in the late 2000s. In the earlier period lending limits approached:
- Up to 3.0 to 4.5 times leading (next year’s) earnings before interest, tax, depreciation, and amortization (EBITDA) for senior lenders.
- Up to 1.0 to 2.0 times leading EBITDA for typical subordinated or mezzanine lenders.
- Interest expense coverage was 1 to 1.25 times leading EBITDA.
- In today’ lending climate ...
