Buyers arrive at a price first and a capital structure second. Lenders work in the opposite order, and the number they produce is not a negotiation. It is the output of two tests, and the binding one is whichever gives the smaller answer.
What is debt capacity?
Debt capacity is the maximum amount of debt a business can support, measured by two independent constraints: a leverage limit expressed as a multiple of EBITDA, and a coverage test measuring whether cash flow services the resulting debt with a margin.
Capacity is a property of the target, not of the buyer’s enthusiasm. Paying more does not increase it. It increases the equity cheque.
The two tests, and which one binds
The leverage test asks how many turns of EBITDA the lender will advance. A senior lender might cap total senior debt at 3.0x EBITDA, with a total leverage cap including subordinated debt at 4.0x.
The coverage test asks whether cash flow, after capital expenditure and taxes, covers scheduled principal, interest, and other fixed charges with a cushion. A fixed-charge coverage floor of 1.20x or 1.25x is a common structure. The underlying calculation is in DSCR, FCCR, and the coverage ratios that decide your file.
The two do not agree. A capital-light business with cheap debt can often carry more turns than the leverage cap allows. A capital-intensive one fails coverage well before it reaches the cap. The lender applies the lower of the two answers, every time.
A worked example
A target with $2,000,000 of EBITDA, priced at 5.0x, so $10,000,000.
| Layer | Multiple | Amount | Rate | Annual cost |
|---|---|---|---|---|
| Senior term debt | 3.0x | $6,000,000 | 9.00% | $540,000 interest |
| Senior amortisation | 10% per year | $600,000 principal | ||
| Subordinated debt | 1.0x | $2,000,000 | 12.00% | $240,000 interest |
| Total debt | 4.0x | $8,000,000 | $1,380,000 fixed charges | |
| Equity | $2,000,000 |
Now the coverage test. EBITDA of $2,000,000 less maintenance capital expenditure of $150,000 gives $1,850,000 available for fixed charges. Against $1,380,000 of fixed charges, coverage is 1.34x, which clears a 1.25x floor.
Where the capacity actually stops
Run the test in reverse. At a 1.25x floor, the maximum fixed charges the business supports are $1,850,000 divided by 1.25, or $1,480,000 a year.
The structure above uses $1,380,000, leaving $100,000 of annual headroom. That is the real constraint, and it is small. A modest increase in the senior rate, a faster amortisation schedule, or $200,000 of additional capital expenditure consumes it entirely, and no additional debt is available at any price.
Notice what this means for the buyer: the deal is not constrained by the 4.0x leverage cap, which it has already hit exactly. It is constrained by roughly $100,000 a year of cash flow.
What happens if the price goes up?
Nothing changes on the debt side. Capacity is set by the target’s EBITDA and cash flow, so at 5.5x the purchase price rises to $11,000,000, the debt stays at $8,000,000, and the equity requirement rises from $2,000,000 to $3,000,000, a 50% increase in the cheque for a 10% increase in price.
This is the arithmetic behind the gap that appears late in deals, and the reason the parts of the price that do not get funded matter so much. Those pieces are covered in seller notes, earnouts, and rollover equity.
What raises capacity legitimately?
- Defensible addbacks, because capacity is a multiple of an EBITDA figure that survives diligence rather than the one in the CIM. The distinction is in addbacks that survive diligence.
- A revolver sized off collateral, which funds working capital without consuming term leverage. The mechanics are in borrowing base certificate.
- Longer amortisation, which lowers annual principal and lifts coverage without changing the leverage multiple.
- A subordinated layer with interest that partly accrues, which reduces cash fixed charges in the early years.
What does not raise it?
Optimism about synergies. Lenders underwrite the entity that exists, and pro forma adjustments for a combination that has not happened yet get a hard read, as described in pro forma EBITDA. Integration costs that were never modelled work in the other direction entirely, which is the subject of integration debt.
The short version
Debt capacity is the lower of a leverage cap and a coverage test, and on most middle-market deals the coverage test binds first. Run it in reverse before agreeing a price: the number that matters is not the multiple, it is how many dollars of annual headroom sit between the structure and the covenant floor.