Determining Debt Capacity: How Much Leverage Can Your SMB Acquisition Handle?

So you found this perfect little business to buy — a small but profitable operation with $1 million in EBITDA/SDE. It’s humming along, making money, and just waiting for you to swoop in and take over. But here’s the big question: what will it really cost you, and how long will you be chained to paying off the debt?

Let’s say you borrow $3 million to make it happen. Sounds straightforward, right? Not so fast. At a 7% interest rate over 7 years, you’ll owe about $552,000 a year just to service that debt. That’s over half — 55.2%, to be exact — of that sweet $1 million in EBITDA/SDE is gone, poof, before you even get a taste of it. Now, if you were to stretch yourself further and borrow $4 million instead, you’d be coughing up 73.6% of EBITDA/SDE each year, leaving a mere $264,000 in cash after debt payments — compared to the $448,000 left if you stick to a $3 million loan.

In the end, multiples matter. A lot. You need a deal with enough room to breathe, reinvest, and maybe even sleep at night.

A Tale of Two Deals

Let’s look at the annual debt payments for a business with $1 million in EBITDA/SDE and $4 million in debt. We need to consider loan terms, specifically the interest rate and loan amortization period.

1. Interest Rate: Assume a 7% interest rate, which is fairly typical for business loans, though it can vary.
2. Loan Term: Assume a 7-year term, which is common for business acquisition loans.

Using these assumptions, we can calculate the annual debt payment.

Annual Debt Payment Calculation

For a $4 million loan at 7% interest over 7 years, we can use a loan amortization formula to find the annual payment.

• Loan principal ($4 million),
• Monthly interest rate (7% annual rate / 12 months = 0.5833%),
• Total number of payments (7 years * 12 months = 84 payments).

After calculating this, the annual debt payment is approximately $736,000.

Impact on EBITDA/SDE

With annual debt payments of $736,000, the business would use around 73.6% of its $1 million EBITDA/SDE on debt payments each year. This leaves only $264,000 (26.4%) of EBITDA/SDE available for other uses, such as reinvestment and owner distributions.

Key Considerations

1. Cash Flow Tightness: Using over 70% of EBITDA/SDE for debt payments is high, making cash flow tight for operational flexibility.
2. Financial Risk: With so much of EBITDA/SDE going toward debt, the business could face financial strain if EBITDA/SDE declines or unexpected expenses arise.

Ideally, you’ll want to keep debt payments closer to 50% or less of EBITDA/SDE to maintain greater financial stability.

Now let’s take a look at a 3x scenario for our SMB:

Assumptions

Let’s keep the same loan terms for comparison:

• Interest Rate: 7%
• Loan Term: 7 years

Annual Debt Payment Calculation for $3 Million Loan

Using the same loan amortization formula with a $3 million principal:

1. Monthly Interest Rate: 0.5833% (7% annual rate / 12 months)
2. Loan Term: 84 payments (7 years * 12 months)

After calculating this, the annual debt payment for a $3 million loan is approximately $552,000.

Impact on EBITDA/SDE

With annual debt payments of $552,000:

• This would use 55.2% of the $1 million EBITDA/SDE for debt payments each year.
• The remaining $448,000 (44.8%) of EBITDA/SDE would be available for other needs.

Comparison to the $4 Million Loan Scenario

Debt Payment as a Percentage of EBITDA/SDE:

• $4 million loan: 73.6% of EBITDA/SDE.
• $3 million loan: 55.2% of EBITDA/SDE.

Remaining EBITDA/SDE:

• $4 million loan: $264,000 left.
• $3 million loan: $448,000 left.

Borrowing $3 million would allow the business more breathing room, with almost half of its EBITDA/SDE available after debt payments. This would be a more sustainable level, giving the business greater flexibility for reinvestment, handling unexpected costs, and weathering any EBITDA/SDE fluctuations.

How Much Leverage Can You Handle?

Generally, a business with $1 million in EBITDA/SDE could support debt somewhere between $2 million and $5 million, depending on various factors, including the business’s stability, industry, cash flow predictability, and interest rates.

Here’s how this range can be considered:

Debt-to-EBITDA/SDE Ratio: Lenders often use a debt-to-EBITDA/SDE multiple, which commonly ranges from 2x to 5x. For a business with $1 million in EBITDA/SDE:

• Conservative Leverage (2x EBITDA/SDE): $2 million debt.
• Moderate Leverage (3–4x EBITDA/SDE): $3 million to $4 million debt.
• Aggressive Leverage (5x EBITDA/SDE): $5 million debt.

Interest Coverage Ratio: Lenders also assess whether the business can comfortably meet interest payments, usually targeting an interest coverage ratio (EBITDA/SDE divided by interest expense) of around 1.5x or higher.

Cash Flow Stability: Stable businesses, like those in utilities or essential services, might handle more debt because they have predictable earnings, while a more volatile business might need to stay closer to the conservative side.

Interest Rates and Loan Terms: Higher interest rates reduce the amount of debt a business can sustain because of the impact on monthly payments. Likewise, shorter loan terms demand higher payments, limiting the total loan amount.