How do you assess debt capacity for an LBO target, and what are the key coverage and leverage metrics to monitor?

• A. Sustainable debt capacity using EBITDA, FCF, and cash flow predictability; Track leverage ratios (Net debt / EBITDA), interest coverage (EBITDA / Interest), fixed-charge coverage, and debt service coverage ratio; monitor covenant headroom and refinancing risk.
• B. Use revenue growth alone; monitor gross margin.
• C. Use EV/Revenue and P/E; monitor market cap.
• D. Only monitor debt-to-equity ratio.

Answer: (A)

Assessing debt capacity in an LBO centers on how much debt the target’s cash flows can sustainably support. The strongest approach looks at cash-flow generation and predictability, not just profits. EBITDA is a useful starting point as it approximates operating cash generation before financing and taxes, but you also need to consider free cash flow after maintenance capital expenditures to ensure there is real cash available to service debt. This leads to a set of coverage and leverage metrics that reveal both how much leverage is affordable and how robust the company is under debt service.

Key measures include net debt relative to EBITDA, which shows how many years of an operating earnings proxy would be needed to repay debt. Interest coverage, calculated as EBITDA divided by interest expense, indicates whether operating profits are ample to cover financing costs. Fixed-charge coverage extends this idea to include other fixed obligations like leases, giving a fuller view of cash obligations. Debt-service coverage ratio compares available cash flow to total debt service, capturing the ability to meet both interest and principal payments across the cycle. Together, these metrics help gauge leverage tolerance and the cushion available for downturns or refinancing risk. Monitoring covenant headroom is essential because it signals proximity to constraint thresholds set by lenders, and refinancing risk matters because significant debt maturities require timely and favorable rollovers.

Other options miss the mark because they focus on top-line growth or market valuations rather than the company’s ability to generate and convert cash into debt payments. Revenue growth and gross margin don’t directly reflect cash flow available for debt service, and valuation multiples or market capitalization don’t assess financing capacity. Debt-to-equity is a structural ratio that doesn’t capture cash flow strength or debt service capability.