A Simple Model Concept to Assess Leverage Capabilities in Microsoft Excel

In this article, I break away a bit from Excel specific information to address a fundamental concept related to corporate finance when companies want to issue debt or a private equity firm wants to acquire a company and use leverage. Even in the current environment, there are still some willing traditional and alternative lenders, but it is certainly not as robust as it had been 5 years ago. In any event, the method by which to quickly assess whether or not a company can handle debt is useful in determining which ideas can be acted upon and which ideas should be shelved.

Many years ago in my early days of investment banking, I developed a Quick Look Model for refinancing for our group to assess the capability of companies to issue debt. It was a simple model that required few inputs but could quickly evaluate whether a debt transaction was viable. Beginning with the latest calculated EBITDA, I constructed a forecast based on EBITDA change for a five-year period. Once you have depreciation, capital expenditures, non-cash working capital changes and a tax rate, the model can be constructed.

Staring with the recent history, grow EBITDA by whatever amount is necessary that fits with the latest news and/or understanding of a company's prospects. For example, if EBITDA for the last fiscal year was $100 and the business prospects are steady but not spectacular, you may assume a simple 5% growth rate per annum, so $105 in year 1, $110 in year 2, $116 in year 3 and so on. The next step is to understand depreciation, along with capital expenditures. In the simplest of models, and without detailed information on expenditure plans, analysts will sometimes have depreciation and capital expenditures as offsetting items. In other words, a company will spend enough each year merely to replace the amount of asset depreciation. In this fashion, the net plant, property and equipment will stay the same for the forecasting period. Finally, you need to make some assumption abut working capital uses. For a quickly growing company, it is very likely that cash will be tied up in working capital as inventories and accounts receivables build. For more mature companies, working capital may be consistent over time as the established entities tend to have long-term relationships with suppliers and customers and the swings in net working capital may be less volatile. Whether you use a percentage of revenue approach or other method, this is another subjective input requiring thought by the financial modeler.

One thing to keep in mind is the iteration concept in Excel. In my opinion, it is more appropriate to use the iteration style of modeling for financial purposes to more accurately reflect the inflows and outflows of cash. For example, you could make an assumption regarding the payment of debt that allows the beginning cash balance (say January 1, 2009) to determine the total amount of interest an entity would pay for the calendar year 2009. This is only appropriate if the type of debt is either a non-principal paying loan or one in which only year-end amortizations occur. In the real world, companies borrow from institutions that may impose quarterly or monthly interest and principal payments. By allowing for iteration in your model, you capture interest paid over the course of the year by taking the beginning and ending debt balances and averaging the numbers. You could increase the realism by using monthly or quarterly forecasting periods, but for the most part, the simple average with iteration approach will provide enough of a first cut to make a decision to do further research on a potential project or not.

Whereas in a standard valuation model in which EBITDA is reduced by depreciation to arrive at NOPAT (net operating profit after taxes, or sometimes used interchangeably with EBIT, which is not exactly correct) and then calculate free cash flow, we are looking at this from a debt perspective. As such, the way to quickly determine how much cash is left to repay borrowing, one must subtract interest expense. Again, we are not calculating the value of the firm, but rather, we are analyzing a company's ability to repay debt. EBITDA minus depreciation minus interest expense provides a pretax number that is then taxed at a specified corporate rate. To reiterate, this interest expense will be based on average balances and thus, the iteration box must be clicked in Excel.

Thus, top of your quick look model (the mini income statement information) will have a net income number plus depreciation minus capital expenditures and changes in non-cash working capital to arrive at cash available to retire debt. The bottom should have the debt balances and cash balances, which will adjust over time depending on the forecasted performance of the company. The change in debt balance will be based on the cash available to retire debt and may or may not include a minimum cash balance constraint or other minor adjustments a financial modeler may incorporate. Once the assumptions are completed, you can quickly see if a company can support debt. Some additional calculations might include coverage ratios (EBITDA/interest, EBIT/ interest) and leverage ratios (total debt/EBITDA, total debt/(EBITDA – capex)). These are the types of ratios that lender will study before determining whether or not a company can support leverage.

The key here is that you can make it as simple or a bit more detailed as you would like, but this would likely take an intermediate financial modeler no more than an hour to setup, quickly research and analyze the merits or drawbacks of a potential project. Sometimes, the most effective approach is a simple one.