Applied analysis
The lender's view
Size Rawdah's debt capacity with coverage, leverage, cash flow and covenant headroom — then test a new loan request.
Learning objectives
- Calculate leverage, coverage and cash-flow-to-debt metrics over three years
- Calculate covenant headroom and the EBITDA cushion before a breach
- Test a new borrowing request on a pro forma basis and judge whether to lend
An equity investor asks how much the company could earn. A lender asks a narrower, sharper question: will I be repaid, even if things go wrong? The upside is capped at the interest rate, so the lender's analysis is all about the downside.
The lender works through three questions:
- Capacity: how much debt can the earnings support? (net debt ÷ EBITDA)
- Affordability: can the company pay the interest comfortably? (EBIT or EBITDA ÷ interest)
- Repayment source: does the business generate cash after investment to reduce debt? (free cash flow ÷ debt)
Loan agreements turn the first two into covenants: limits that, if broken, let the lender demand repayment or renegotiate. Rawdah's (fictional) bank facility allows net debt of up to 3.0x EBITDA and requires interest cover of at least 3.0x. Rawdah has now asked the bank for a new SAR 100m term loan at 7.0% to fund store openings.
Headroom = Max leverage × EBITDA − Net debt EBITDA cushion = 1 − Net debt ÷ (Max leverage × EBITDA) EBIT cushion = 1 − Min cover × Interest ÷ EBIT
- Headroom
- how much more net debt the covenant allows at today's EBITDA
- EBITDA cushion
- how far EBITDA can fall, with debt unchanged, before net debt ÷ EBITDA hits the covenant
- EBIT cushion
- how far EBIT can fall before interest cover hits its minimum
- Pro forma
- the latest figures restated as if the new loan were already drawn (and its cash spent)
Included with a Formula Quest membership
The rest of this lesson is for members. Members get the full lesson, including its 3 graded exercises, and every other Finance Quest lesson.