Sources and uses, the target's full twelve months, the synergy line kept separate, and why a debt-funded bolt-on at 8.0x levers up a borrower at 3.33x.
Pro forma leverage is the debt and cash the borrower will have the day after closing, divided by the buyer's and the target's EBITDA for the same full twelve months, as if the deal had happened at the start of the period. On an illustrative borrower at 3.33x net that buys an 8.0 EBITDA business for 64.0, pro forma net leverage is 4.37x. Add the 3.0 of synergies the sponsor presents and it reads 4.05x: the 0.32 of a turn between the two is the credit decision.
Worked in full in Credit Analysis by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The ratio itself is the one worked in how to calculate net debt to EBITDA. What changes in an acquisition is that both sides of it move at once, and each side has a choice hidden in it: which debt and cash survive the sources and uses, and which EBITDA the lender agrees to count for a business it has not yet owned for a year.
| Input | Value |
|---|---|
| Buyer EBITDA, last twelve months, lender's basis | 30.0 |
| Buyer term loan | 120.0 |
| Buyer cash before the deal | 20.0 |
| Target EBITDA, last twelve months | 8.0 |
| Purchase price (enterprise value, 8.0x) | 64.0 |
| Transaction costs | 2.0 |
| Incremental term loan raised | 50.0 |
| Run-rate synergies claimed | 3.0 |
| Maximum net leverage covenant | 4.50x |
Before the deal the borrower carries 120.0 of debt and 20.0 of cash: net debt of 100.0 on 30.0 of EBITDA, or 3.33x. Gross leverage is 4.00x.
Step 1: sources and uses. The uses are the price plus the costs, 64.0 + 2.0 = 66.0. The sources are the new loan of 50.0 and 16.0 of the buyer's own cash, which leaves 4.0 on the balance sheet. Costs paid in cash belong in the uses: they are cash gone, whatever the income statement later does with them.
Step 2: pro forma net debt. Debt becomes 120.0 + 50.0 = 170.0. Net of the 4.0 of cash left, net debt is 166.0. Any debt the target brings across, and any debt-like claims such as an earn-out or deferred consideration, are added here.
Step 3: pro forma EBITDA. Add the target's full last twelve months to the buyer's: 30.0 + 8.0 = 38.0. This is the convention credit agreements use for a permitted acquisition, and the right one, because the debt to buy the whole year of earnings is already on the balance sheet.
Pro forma net leverage = (existing debt + new debt − cash left) ÷ (buyer EBITDA + target EBITDA)
= (120.0 + 50.0 − 4.0) ÷ (30.0 + 8.0) = 166.0 ÷ 38.0 = 4.37x
In Excel: =(Debt+NewDebt-(Cash-(Price+Fees-NewDebt)))/(EBITDA_B+EBITDA_T)
Step 4: synergies, separately. With 3.0 of run-rate synergies the denominator is 41.0 and leverage reads 4.05x. Show both lines. The first is what the business earns today; the second is a forecast, and if the credit agreement lets it be counted, it is also the number the covenant will be tested on.
The deal adds 66.0 of net debt (166.0 less 100.0) for 8.0 of EBITDA. The debt-funded multiple is 8.25x, against existing leverage of 3.33x. Any acquisition funded with net debt at a multiple above the borrower's own leverage raises leverage, and by a lot: to keep the ratio at 3.33x, 66.0 of debt would need to buy 19.8 of EBITDA, a price of 3.23x. No seller accepts that, which is why debt-funded buy-and-build strategies move leverage up first and rely on growth and synergies to bring it back.
The equity cheque that would keep leverage flat is 166.0 less 3.33x of 38.0, so 166.0 − 126.67 = 39.33. A sponsor proposing a debt-funded deal with no equity is asking the lender to fund that gap.
At 4.50x the covenant allows 171.0 of net debt on 38.0 of EBITDA, so the deal leaves 5.0 of debt room. Read the other way, EBITDA can fall to 166.0 ÷ 4.50 = 36.89 before a breach: a cushion of 1.11, or 2.92 per cent. On the synergy number the same test shows 4.11 of cushion and 10.03 per cent. In turns, 0.13 against 0.45. Every bit of comfort in the second figure comes from earnings that do not exist yet. The mechanics of the cushion are in how to calculate covenant headroom.
| Price multiple | Price | PF net debt | Leverage | With synergies |
|---|---|---|---|---|
| 6.0x | 48.0 | 150.0 | 3.95x | 3.66x |
| 7.0x | 56.0 | 158.0 | 4.16x | 3.85x |
| 8.0x (base) | 64.0 | 166.0 | 4.37x | 4.05x |
| 9.0x | 72.0 | 174.0 | 4.58x | 4.24x |
| 10.0x | 80.0 | 182.0 | 4.79x | 4.44x |
Each turn of purchase multiple on an 8.0 EBITDA target adds 8.0 of debt and about 0.21 of a turn of leverage. At 9.0x the deal breaches the covenant on day one unless the synergies are counted, and at 10.0x it passes only with them.
| Sponsor equity | PF net debt | Leverage |
|---|---|---|
| 0.0 | 166.0 | 4.37x |
| 10.0 | 156.0 | 4.11x |
| 20.0 | 146.0 | 3.84x |
| 30.0 | 136.0 | 3.58x |
The first is the one sponsors make: putting the synergies in the headline. A pro forma figure of 4.05x describes a business that will exist only if the integration plan works. The lender's number is 4.37x, with the synergies shown as an upside line beneath it, and the add-back of synergies limited to what the agreement caps.
The second is the one lenders' own monitoring makes after closing. If the deal completes four months before a test date and the compliance certificate takes the buyer's reported last twelve months, the target contributes only four months of EBITDA: 30.0 + 2.67 = 32.67. Divided into 166.0 that is 5.08x, 0.58 of a turn over the covenant, a breach that does not exist. The missing 5.33 of target EBITDA is exactly what the pro forma clause adds back. Get the clause right in both directions: it should add the target's historical year, not the year management now forecasts for it.
Check the target's EBITDA as hard as the buyer's. A seller's 8.0 usually comes with its own add-back bridge. Every 1.0 that falls away after closing costs about 0.12 of a turn here, and there is no headroom to absorb more than one of them.
Build pro forma leverage from the sources and uses, not from a press release: debt after the deal, less the cash actually left, over both companies' full twelve months. Show the synergy case on a separate line, compare the debt-funded multiple with the borrower's own leverage, and state the cushion in per cent of EBITDA. Here: 4.37x, a debt-funded multiple of 8.25x and 2.92 per cent of headroom. The covenant test beside it, on the book's own borrower, is in the free workbook for this case.
Show them, but on a separate line. Pro forma leverage on the two companies' actual earnings is the lender's figure: 4.37x in the example. Counting 3.0 of run-rate synergies lowers it to 4.05x, worth 0.32 of a turn, but that EBITDA does not exist until the integration delivers it. If the credit agreement allows the add-back, it should be capped and time-limited.
Yes, unless it is repaid at closing out of the sources. Any debt assumed, plus deferred consideration or an earn-out that behaves like debt, is added to pro forma net debt. In the example, assuming 10.0 of the target's debt instead of refinancing it takes net debt to 176.0 and leverage from 4.37x to 4.63x, above a 4.50x covenant.
Because the debt is raised at the purchase multiple, not at the borrower's leverage. Paying 66.0 of new net debt for 8.0 of EBITDA is 8.25x, far above the buyer's 3.33x, so the combined ratio rises to 4.37x. Holding leverage flat would need 39.33 of sponsor equity, or a target bought at 3.23x.
This article is one calculation from Credit Analysis. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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