Debt capacity: how much debt your company can safely carry

Debt is one of the most powerful tools available to an owner, and one of the most misunderstood. Sized well, it funds growth without diluting your equity, smooths out cash needs and lifts the return on the capital you have invested. Sized badly, it turns a routine dip in sales into a liquidity crisis, and it is almost always liquidity, never accounting profit, that brings down an otherwise profitable company.

This guide is written for owners of SMEs and startups, and for the buyers and investors who have to judge how much debt a target can carry. It answers a single question, but in depth: how much debt can your company repay calmly, including in a bad year? The answer is not the amount the bank is willing to lend. It is a figure you can work out yourself, with a handful of ratios and a little discipline.

Debt capacity versus the bank appetite

First distinction, and a fundamental one. What the bank offers depends on its collateral, its policy of the moment and your track record with it. Your real debt capacity depends only on the cash your operations generate and on how stable that cash is. The two rarely coincide. A well secured bank can lend you beyond what you can prudently repay; a cautious bank can refuse a perfectly sustainable loan. Your job as an owner is to know your own limit before you walk into the banker's office.

Debt capacity is measured on three complementary planes: the size of the debt stock against your earning power, your ability to make the instalments year after year, and the strength of your balance sheet. None of the three is enough on its own. A company can show a flattering debt ratio and still default because its instalments fall due too quickly; another can cover its instalments comfortably and stay fragile because its equity is too thin. So we look at them together.

The starting point: a normalised EBITDA

Everything starts from EBITDA, the operating result before interest, taxes, depreciation and amortisation. We prefer it to net profit because it is the closest proxy for the cash the business generates to service debt, independent of the financing structure and the depreciation policy. But a raw EBITDA pulled straight from the accounts is useless: it has to be normalised, that is, brought back to what the business genuinely and durably earns.

Normalising means making four kinds of adjustment. First, strip out non recurring items: a gain on a disposal, an exceptional dispute, a one off grant. Second, bring the owner's pay back to a market level, because an artificially low salary inflates EBITDA and creates a fictitious capacity. Third, add back purely personal costs run through the company. Fourth, correct scope anomalies, such as an off market rent paid to a property company owned by the owner. This is exactly what the bank will do, and what a buyer will do, so you may as well do it first for yourself.

Here is the example we will carry through end to end. A services SME, or an already profitable startup, has revenue of 4,000,000 euros. Its reported result is modest, but after normalisation EBITDA comes out at 600,000 euros. It is this figure, and this figure alone, that anchors every ratio below. The accounting net profit, at 250,000 euros, is of no use here.

Ratio one: net debt to EBITDA

The first indicator banks and investors look at is net debt divided by EBITDA. Net debt adds up all your financial liabilities (bank loans, leases and lease purchase, financial shareholder current accounts, permanent overdrafts) and subtracts the cash genuinely available. The ratio reads in years: how many years of EBITDA it would take, in theory, to clear all the debt.

• Below 2.0x: comfortable. You keep room to invest or absorb a shock.
• Between 2.0x and 3.0x: reasonable for most stable SMEs and startups, if the cash flows are predictable.
• Between 3.0x and 3.5x: stay alert. Acceptable only with highly recurring revenue (subscriptions, long contracts, rents).
• Above 3.5x: under strain. The slightest slowdown puts the instalments at risk.

In our example, with 600,000 euros of EBITDA, net debt of 1,200,000 euros gives 2.0x: comfortable. At 1,800,000 euros it reaches 3.0x, the reasonable limit. If the owner is considering a new loan of 600,000 euros to fund an investment, the question becomes simple: where does the existing net debt already sit? Starting from 1,200,000 euros, the new loan takes it to 1,800,000 euros, exactly 3.0x. We stay within the reasonable range, but we have used up all the room.

Ratio two: debt service coverage

The debt to EBITDA ratio measures a stock. But what triggers default is not the stock, it is the inability to honour an instalment on a precise date. Hence a second, far more operational test: the debt service coverage ratio, or DSCR. You compare the cash genuinely available to repay with the annual debt service, that is, the principal plus the interest due within the year.

The cash available for debt service is not EBITDA. It is normalised EBITDA, minus the tax you owe, minus essential maintenance investment (renewal capex, not growth projects), minus the change in working capital. That last point is crucial: a growing business ties up cash in its inventory and its receivables, and that cash is not available to the bank.

Back to the numbers. EBITDA of 600,000 euros, minus 90,000 in tax, minus 120,000 of maintenance capex, minus 40,000 of higher working capital, leaves 350,000 euros to service debt. Suppose the existing debt already costs 150,000 euros a year in principal and interest, and the new loan of 600,000 euros over five years at 5% adds around 135,000 euros a year. Total service reaches 285,000 euros. The DSCR comes out at 350,000 over 285,000, or 1.23x.

How should you read that 1.23x? A healthy DSCR sits above 1.3x: for every euro of instalment, you generate at least 1.30 euros of cash. Below 1.2x you have almost no cushion left, and the bank will often ask for additional collateral or a pledge. At 1.23x our owner is just about holding: it is doable, but with no margin at all for a bad year.

The real question is not "how much does the bank want to lend me?" but "how much can I still repay calmly in a year with revenue down 20%?"

The stress test most owners forget

Running these ratios on your best recent year is the most common mistake, and the most costly. Debt has to be repaid in the hard years too, above all in those years. Before you sign, run the full calculation again on a realistic stress scenario: revenue down 15 to 20%, with margin contracting because your fixed costs do not fall at the same pace.

Apply it. If revenue falls 20%, the EBITDA of a business with a meaningful share of fixed costs does not fall 20%, but often 35 to 40%, through operating leverage. Our EBITDA of 600,000 euros could drop to 380,000 euros. After tax, maintenance capex and working capital, the available cash would fall from around 350,000 euros to perhaps 200,000 euros. Against a debt service of 285,000 euros, the DSCR would slump to 0.70x. In other words, in that year the company no longer generates enough to repay and has to draw on its cash or refinance. This is precisely the scenario that should make you step back, or reduce the amount borrowed.

The practical rule: if the DSCR stays above 1.0x in the stress scenario, the debt is sustainable even in a bad year. If it drops clearly below, you are borrowing on your best case and betting that nothing goes wrong. In our example, it would be wiser to cap the new loan at 350,000 or 400,000 euros rather than 600,000, to keep a stressed DSCR close to 1.0x.

The third plane: balance sheet strength

Beyond the flows, look at the structure. Two indicators are enough. First the equity ratio: your equity over total assets. Below 20%, the company is thin and both a lender and a buyer will worry; above 30%, the balance sheet is solid. Second the ratio of net debt to equity (the gearing), which says how far the company is funded by debt rather than by capital. A gearing above 1.5x signals a heavy dependence on credit.

These balance sheet ratios act as an early warning. A company can cover its instalments comfortably today while having equity so thin that a single loss making year would push it into negative equity, with the legal consequences that follow. Debt is therefore never judged by the flows alone: it is also judged by the balance sheet's ability to absorb a loss.

Match the debt to the nature of the asset financed

A common sense rule, yet broken all the time: the term of the financing should match the useful life of the asset financed. You finance premises over fifteen to twenty years, a machine over five to seven years, a vehicle over three to five years, software over three years. Conversely, you never fund operating losses or a structural cash need with a revolving short term credit.

This is the classic trap of the overdraft that never clears. If your current account line never returns to zero during the year, it is not working capital, it is permanent debt in disguise, usually expensive and revocable at any moment. It needs to be restructured into a medium term loan backed by a real asset, otherwise it remains a sword hanging over you.

Covenants: the debt in the small print

Beyond the rate and the term, read the covenants the bank attaches to the loan: a cap on net debt to EBITDA, a minimum DSCR, sometimes an equity floor to respect. A breached covenant, even briefly and even if you keep paying your instalments, can make the whole debt immediately repayable. It is one of the most underrated causes of sudden failure.

Negotiate headroom on these thresholds from the outset. If your debt to EBITDA is 2.0x when you sign, ask for a covenant at 3.0x rather than 2.5x. That headroom is almost free to win up front; it becomes impossible to negotiate once you are in difficulty and need the flexibility most.

The buyer case: debt that funds the acquisition

If you are buying a company, the logic reverses but the tools stay the same. Acquisition debt is repaid with the target's cash flows, not yours. The decisive test is therefore the target's DSCR after the deal, including the acquisition debt in the existing service. The prudent rule is that acquisition debt rarely exceeds 3.0 to 3.5x normalised EBITDA, and that the post deal DSCR stays above 1.3x.

Watch two traps. First, the EBITDA the seller presents is almost always optimistic: normalise it yourself, without indulgence, because it is your repayment capacity that is on the line. Second, check that the target can keep investing in its assets while you repay; debt that drains all the maintenance capex condemns the business over the medium term, even if the first instalments go through.

The direct link with the value of your business

Your debt structure weighs on what you walk away with on the day you sell. Most deals are done on a "cash free, debt free" basis: the buyer takes over the business without its financial debt, and that debt comes off the price paid. Healthy debt, backed by assets and well documented, comes off cleanly and raises no question. Badly structured debt, vague shareholder current accounts, short term lines that in reality fund operations: all of this complicates the negotiation, puts the buyer on edge and ends up eating into the price.

Controlled leverage is therefore not just a survival question. It signals the quality of your management, reassures the banks while you are at the helm, and gets paid for in the price on the day you hand over. Both goals, strength today and value tomorrow, point the same way.

The checklist before you sign

• Is my EBITDA genuinely normalised (market pay, exceptional items removed, personal costs added back)?
• Does my net debt to EBITDA stay below 3.0x after the new financing?
• Is my DSCR above 1.3x in a normal year?
• Does my DSCR stay above 1.0x in a stress scenario with revenue down 20%?
• Does the term of the loan match the useful life of the asset financed?
• Have I negotiated headroom on the covenants relative to my current position?
• Does my equity stay above 20% of the balance sheet, with a buffer to absorb a loss making year?
• Have I kept a cash reserve separate from the loan, so I do not depend on the bank at the first surprise?

If you answer yes to these eight questions, the financing strengthens your business. If you stumble on two or three, it is not necessarily a refusal: it is often a signal that you should reduce the amount, lengthen the term or restructure the existing debt before adding more.

From the framework to your specific case

This guide gives you the full method, but the answer depends on figures specific to your business: your genuinely normalised EBITDA, your maintenance capex, the dynamics of your working capital, the stability of your cash flows. That is exactly the kind of question a fractional CFO works through with you. In a diagnostic call we lay out your ratios, measure your real repayment margin, and tell you in one conversation whether the financing on the table strengthens or weakens your business. Book that call: you will leave with a number, not an impression.