Debt capacity

Debt capacity is a property of the cash flows rather than of the assets on the balance sheet. What lenders underwrite is the reliability of the cash left after tax, capital expenditure and working capital, because that is what pays interest and repays principal. A business with steady, contracted, low capital intensity earnings supports several turns of EBITDA. A business with the same EBITDA arriving unpredictably supports far less, at a wider spread, with tighter covenants.

This is why the same headline multiple means different things for different businesses. Leverage is what lets a financial buyer bid competitively, so a business with little debt capacity is one where a sponsor cannot get close to a strategic buyer, and the ability to pay band on a valuation page stops being informative.

Capacity also moves with the market rather than only with the company. The same cash flows attract more debt in a benign credit environment than in a tight one, which is the main reason precedent multiples struck a few years apart can be so far apart with nothing having happened to the businesses involved.

The practical test in an interview is to ask what would happen to the interest bill in a bad year. If a plausible downside takes cash generation below the cost of the debt, the capacity is not there whatever the current year's ratios suggest, and that is the question a credit committee asks first.