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Leverage and Debt Sizing

Lenders consider the serviceability of the loan of prime importance and build a framework of financial covenants and other conditions to ensure that their debt remains whole, is well-serviced, and repaid as per the pre-agreed amortisation profile.

Lenders tend to determine the debt size and its serviceability from several quantitative and qualitative factors with Leverage being one of the important quantitative factors.

Leverage is the ratio of Bank Debt and EBITDA i.e., Bank Debt/EBITDA; it reflects a company’s ability to support debt. A low ratio signals positively on the debt serviceability whereas a higher ratio reflects vulnerability to debt serviceability. Conceptually, a Leverage of say 4x means that it takes four times current earnings (EBITDA) to service the debt.

Company’s need to do a balancing act while their profitability is under strain; as the Leverage moves northwards for the same amount of Debt, which could result in a breach of leverage covenant. The cure for such a situation is to either increase the EBITDA (if possible) or settle part of the Debt by accruals or by shareholder infusion.

A high level of Debt/EBITDA (say above 5x) reduces the probability of mobilisation of new Debt by the company. In this scenario, the lenders need to be informed that the situation is temporary in nature and would get corrected in a short period of time in the future.

Companies with aggressive growth plans tend to have a high Debt/EBITDA, especially during the initial years of availing the Debt. Lenders accept this position with a financial covenant on Leverage such that the financial covenant level slides down over the tenor of the Debt.

A drawback of Debt/EBITDA is that it does not recognise the amortisation profile of the Debt. Hence, a company with majority of its Debt being short-term and another company with equal EBITDA and with majority of its Debt being long-term will have the same Debt/EBITDA. However, from Debt Serviceability perspective, the company with longer debt maturity is better placed.

Leverage is a Debt sizing ratio and facilitates in determining the sustainable debt. It’s complimented with Debt Service Coverage Ratio (DSCR) to find the debt serviceability of a company.

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