The debt to EBITDA, or debt to FFO multiple, is the most common quoted ratio for debt capacity. The logic behind this is that for a given amount of debt in the numerator, the earnings or cash flow divided into that amount tells us approximately how many years it would take to pay down the debt. It is a very simple back-of-the-envelope calculation, as it does not include interest and it does not allow for earnings growth. If there is a standard or threshold multiple that the market is currently allowing for certain size companies to borrow, let's say 5x, we would multiply that by the company's earnings or cash flow, whichever the multiple was based on, and determine the capacity. In this example, we see how this works. We have a 5.5x multiple. We have a driver of LTM EBITDA of 1200, so the debt capacity of this particular company would be 5.5x times 1200 or 6,600. We can also use multiple in a different way, which would be to take forward year one EBITDA to interest expense multiple, say of three times, and then apply that to the target companies forward year one EBITDA of 1260 and assuming a current interest rate of 6% and we could actually back into a max interest expense that they could use, as well as a max debt capacity. It's not used as frequently with interest expense as it is for overall debt capacity. One of the issues with multiples is that if you look at various industries, EBITDA has inconsistencies inherent. So here's a manufacturer that has a low cash conversion from EBITDA due to high CapEx requirements and a negative working capital cash flow. This second example is a publisher that has a very high cash conversion. due to the fact that it's working capital cash flow is positive and it has relatively low CapEx. So in these two scenarios, the EBITDA multiple is misleading. Once again, we come back to the realization that EBITDA is only an approximation for cash. To get to free cash flow, we begin with EBITDA, then we must consider interest, taxes, changes in working capital, changes in other operational assets and liabilities, and finally, CapEx. All of these must be paid in a real world situation before it can be determined if the company has additional room for leverage. We can also make this calculation using net income. We would add depreciation and amortization. We would then have to adjust for any non-cash items, like PIK debt, then we would adjust for changes in working capital, changes in operational assets and liabilities. Here's where we might adjust, as well, for any taxes that were not paid in cash, such as deferred taxes. And lastly, CapEx. To calculate the debt capacity using the free cash flows, first, we would take the sum of the cash flows discounted each year by the after tax cost of debt. This is also called the NPV, or net present value. The interest in each year is calculated based on the outstanding balance and the debt repayment each year is the free cash flow in that year minus the interest paid. If the calculations are correct, by the end of the loan term, the balance should go to zero. One question we might have here is why don't we include the interest on the new debt in the free cash flow? This is a valuable exercise and an excellent starting point. It should be kept in mind, though, that neither banks nor the markets, nor the issuer, would want to borrow an amount where every available dollar has been spoken for and there is no room for error. So this is really only the beginning of structuring a loan.
