How Much Debt Can Your Business Really Support?

Key takeaways

• A lender's headline multiple (for example 2.5x EBITDA) tells you what they might offer, not what your business can comfortably repay.
• Debt is repaid from cash, not profit. The gap between the two is often wider in owner managed businesses than directors expect.
• Director drawings and dividends, tax timing, leases and working capital are the usual reasons a profitable business is offered less than it hoped.
• Lenders test the downside as well as the base case. The downside test is frequently the one that sets the limit.
• You can improve your borrowing capacity before you approach a lender, and it is worth doing.

The headline multiple is not the real test

Your bank says it can lend you 2.5 times EBITDA. That sounds like an answer. It is really a starting point.

Leverage multiples are useful for screening and for comparing deals, which is why you will see them in most term sheets. But when an underwriter sits down to approve the loan, the question is different: after everything the business and its owners need to pay out, is there enough cash left to meet the repayments, even if trading is worse than planned?

This article walks through how that question is answered, using a realistic example for a business with around £1.5m of EBITDA, so you can see how your own numbers are likely to be read.

EBITDA versus free cash flow: a worked example

EBITDA measures trading profitability before interest, tax, depreciation and amortisation. It is a good yardstick for performance. It is not the cash available to repay a lender.

The measure underwriters care about is the cash left after the unavoidable outflows. You may see it called free cash flow, cash available for debt service, or in larger transactions CFADS (cash flow available for debt service). They all mean the same thing in practice: what is genuinely left to pay the bank.

Here is an illustrative example: a UK distribution business with £1.5m of EBITDA, owned and run by its directors.

Table 1: From EBITDA to cash available for debt service

Only 42p of every £1 of EBITDA is available to repay a lender. That is not unusual. For many owner managed businesses it is typical, and it is why the same EBITDA can support very different amounts of debt in different companies.

How the cash figure turns into borrowing capacity

Lenders then compare cash available with the repayments the new debt would require. This is the debt service cover ratio, or DSCR:

DSCR = cash available for debt service ÷ (interest + scheduled capital repayments)

Assumptions for this illustration: a five year term loan at 8% interest, repaid in level annual instalments. Figures are rounded and the structure is simplified.

The downside case is the binding constraint, so a prudent underwriter would size this loan at around £1.7m, or roughly 1.1x EBITDA, well short of the 2.5x (£3.75m) headline multiple.

To see why the headline figure does not work, look at what a £3.75m loan would do to cover:

Any cover below 1.0x means the business cannot meet its repayments from cash generated. The multiples look similar on paper. The cash tells a very different story.

This is illustrative only. The real outcomes depend on the lender, the sector, the security offered, the term and the interest rate. Each lender is nuanced around the key concept.

What actually gets deducted

If you want to estimate your own position, these are the items an underwriter will look for between EBITDA and the cash available to repay debt.

1. Working capital. Growing businesses absorb cash in stock and debtors. Lenders will look at debtor days, stock turn and creditor days, and will test whether your working capital needs are seasonal or structural.
2. Maintenance capital expenditure. The spend needed to keep the business running at its current level, not growth investment. Underwriters often compare this with depreciation.
3. Leases and hire purchase. Existing HP, finance lease and asset finance payments are fixed commitments that rank ahead of your new borrowing in practice.
4. Tax. The cash paid, and when. Corporation tax, VAT and PAYE timing matter, and lenders check HMRC positions closely. Arrears or a Time to Pay arrangement will be noticed and can be decisive.
5. Director drawings and dividends. This is the one directors most often overlook. In an owner managed business, a lender will ask what you and your co-owners need to take out to live on, and will usually assume a sensible level continues. Strong profit with high drawings can leave very little to service debt.
6. One off and exceptional costs. Restructuring, legal costs or an unusual contract loss will be considered, along with whether they are likely to recur.

DSCR and covenants in plain English

We have already used DSCR above. In practical terms:

• Base case cover is tested on your forecast. Many lenders look for something in the region of 1.25x to 1.5x, so that cash available exceeds repayments by a comfortable margin.
• Downside cover is tested after reducing revenue or margins. Lenders commonly want to see the business still covering repayments, often at around 1.0x to 1.1x or above.
• Covenants are the conditions written into the facility, such as minimum cover, maximum leverage or minimum liquidity. They are tested regularly, and a breach can allow the lender to renegotiate terms or, in the worst case, demand repayment.

These ranges are indicative and vary by lender, sector and security. Ask for covenants that reflect how your business really trades. A seasonal business, for example, may need tests that smooth out the peaks and troughs, not a snapshot at a low point.

As we discussed in our previous article (Covenant Headroom: Why It Matters More Than Pricing), covenant headroom matters just as much as the covenant itself. A covenant you pass today by a whisker is a covenant you may breach next year.

How different lenders view the same business

When directors say "the bank", they usually mean their own current bank. In reality there are several types of lender, and they look at the same company differently.

• High street and clearing banks tend to focus on cash flow, track record and the strength of the relationship. Appetite is often more conservative on acquisitions and weaker credits.
• Challenger and specialist banks may be more flexible on sector or structure, and often more commercial on speed, sometimes at a higher price.
• Asset based lenders and invoice finance providers look first at what they can lend against: debtors, stock, plant and property. They can release more cash than a cash flow loan where the balance sheet is strong.
• Private credit and debt funds can offer higher leverage and more flexible structures for larger or more complex transactions, usually at a higher cost.

For UK SME acquisitions, senior cash flow lending is often in the region of 2x to 3x EBITDA, with higher totals generally needing asset security, deferred or vendor consideration, or additional equity or mezzanine support. These are indicative ranges only and move with credit conditions.

The right lender for your business depends on what you are borrowing for, what you can offer as security, and how quickly you need to move.

Five ways to increase your borrowing capacity before you approach a lender

1. Review drawings and dividends. In our example, reducing drawings by £100,000 a year lifts cash available in both cases and increases indicative borrowing capacity by roughly £350,000. Even a temporary, agreed reduction can change the outcome.
2. Tidy up your working capital. Faster debtor collection, tighter stock control and better supplier terms release cash and reduce lender concern.
3. Clean up your HMRC position. Bring VAT, PAYE and corporation tax up to date before you apply.
4. Build forecasts a lender will believe. Underwriters apply heavy haircuts to optimistic projections. Explain assumptions, show a downside case, and be ready to defend every line.
5. Match the structure to the need. The right mix of term debt, revolving facilities, asset finance or invoice finance, with repayments that follow your cash generation, can unlock more than a single large loan.

Conclusion and next step

How much debt a business can support is a cash question, not a multiple question. EBITDA is where the analysis starts. The cash left after working capital, capex, leases, tax and the owners' own needs is where it ends.

Before you approach a lender, work out your own version of Table 1. It will tell you what you can realistically afford, what a lender is likely to offer, and where the gap is.

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Frequently Asked Questions

What is the difference between EBITDA and free cash flow?

EBITDA is a measure of trading profit before interest, tax, depreciation and amortisation. Free cash flow (what lenders may also call cash available for debt service) is what is left after working capital movements, maintenance capex, leases and hire purchase, tax and, in owner managed businesses, director drawings and dividends. EBITDA shows how well the business trades. Free cash flow shows what is available to repay a lender.

How much can I borrow against my EBITDA?

There is no single answer. For UK SME acquisitions, senior cash flow lending is often in the region of 2x to 3x EBITDA, but the amount a lender will actually offer depends on your cash flow, security, sector, track record and the term of the loan. As the worked example above shows, a business can be offered a headline multiple that its cash flow cannot comfortably support. Treat multiples as a guide and test the repayments.

What debt service cover ratio (DSCR) do lenders look for?

Many lenders look for roughly 1.25x to 1.5x in the base case, and for the business to still cover its repayments in a downside case, often at around 1.0x to 1.1x or above. These are indicative ranges and vary by lender, sector and security.

Will I have to give a personal guarantee?

Often, yes, particularly for smaller owner managed businesses. Guarantees can sometimes be limited to a capped amount or a percentage of the facility, and may fall away as the loan is repaid or the business strengthens. Take independent legal advice before signing and negotiate the scope where you can.

Do lenders really look at what I take out of the business?

Yes. Drawings and dividends are one of the first things an underwriter checks in an owner managed business, because they come out of the same cash that would repay the loan. If your current level is high, expect the lender to assume it continues unless you agree to reduce it.

Can I borrow more if I offer security?

Often you can. Security such as property, plant, stock or debtors can support higher borrowing, particularly with asset based lenders. Security does not replace cash flow though. Most lenders still want to see that the business can service the debt without relying on selling assets.

Will an HMRC arrangement stop me getting funding?

Not necessarily, but it will be noticed. Lenders look at whether arrears are historic or current, whether you are keeping to the arrangement, and why it was needed. Bringing VAT, PAYE and corporation tax up to date before you apply, and being ready to explain what happened, improves your position considerably.

What is the difference between cash flow lending and asset based lending?

Cash flow lending is sized mainly on the profits and cash the business generates, and is common for term loans and acquisitions. Asset based lending, which includes invoice finance, is sized mainly on the value of assets such as debtors, stock and plant. Businesses with strong balance sheets but modest profits may find asset based lending releases more cash. Many businesses use a combination.

Why might a lender offer less than I asked for?

The most common reasons are high owner drawings, forecasts the underwriter does not believe, customer concentration, weak or late management information, unexplained changes in margin, an unresolved HMRC position, and downside cover that falls below the lender's minimum.

Should I just ask my own bank?

Your existing bank is a sensible place to start, but it should not be the only one you speak to. Different lenders have different appetites, sector preferences and structures, and the same business can receive very different offers. Comparing options, or taking advice on who is likely to be the best fit, can improve both the amount and the terms.

Where can I get help working out how much my business can borrow?

Oakmead Finance can help you build your own version of the cash flow analysis in this article, test the downside and approach suitable lenders. Speak to us for a no obligation conversation.