A Growth Story with a Working-Capital Warning
You are a credit analyst at a mid-market lender reviewing Northline Components for a sponsored acquisition. Revenue is $520 million, EBITDA is $78 million, and the proposed debt package is $390 million at SOFR+425, seven-year maturity. Financial covenants are maximum leverage of 4.75x EBITDA and minimum interest coverage of 2.25x. The sponsor also wants a $60 million dividend recapitalization at close, to be funded with additional debt. FY25 shows revenue growth of 18% and EBITDA growth of 9%, but operating cash flow was only $31 million, capital expenditures were $34 million, and dividends were $12 million. Receivables rose to $111 million (78 days) from $82 million (58 days); inventory rose to $96 million (101 days) from $74 million (82 days); payables rose to $58 million (61 days) from $50 million (55 days). Management projects EBITDA of $88 million next year. There are no lease adjustments.
1. Calculate FY25 free cash flow after capex and dividends, and explain the working-capital drain.
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Free cash flow after capex and dividends is CFO 31 − capex 34 − dividends 12 = −$15 million. The cash conversion cycle is 78 + 101 − 61 = 118 days, versus 58 + 82 − 55 = 85 days a year earlier, a 33-day deterioration. Using revenue of $520 million, daily revenue is 520/365 ≈ $1.425 million, so 33 extra days absorb roughly $47 million. The balance-sheet changes confirm the pattern: receivables used $29 million, inventory used $22 million, and payables provided only $8 million, a net $43 million working-capital use. EBITDA growth of 9% is therefore not converting into cash; growth is being financed by the balance sheet, which is exactly the wrong profile for a leveraged recapitalization.
2. Calculate pro forma leverage and interest coverage at close, and assess covenant headroom. Assume SOFR is 5.0% and there is no amortization.
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Pro forma debt is 390 + 60 = $450 million. Leverage is 450/78 = 5.77x, above the 4.75x maximum. The interest rate is 5.0% + 4.25% = 9.25%, so annual interest is 450 × 9.25% ≈ $41.6 million. Coverage is 78/41.6 ≈ 1.87x, below the 2.25x minimum. Even before the dividend recap, the $390 million package gives 390/78 = 5.00x leverage and 36.1/78 coverage of 2.16x, so the deal already breaches both covenants at close. The recap does not create the problem, but it makes the breach larger. There is no covenant headroom; the deal requires more equity, less debt, or a delayed dividend.
3. What EBITDA level is needed to satisfy both covenants at close if total debt is $450 million and the interest rate is 9.25%? What recommendation follows?
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Leverage requires EBITDA of at least 450/4.75 = $94.7 million. Coverage requires EBITDA of at least 2.25 × 41.6 = $93.7 million, so $94.7 million is the binding threshold. Current EBITDA is $78 million and next-year guidance is $88 million, still $6.7 million short. To close at $88 million EBITDA, maximum debt under the leverage covenant is 4.75 × 88 = $418 million; coverage allows about 88/(2.25 × 9.25%) ≈ $423 million. The binding constraint is therefore about $418 million. The sponsor must contribute at least 450 − 418 = $32 million more equity, or eliminate the $60 million dividend, and should also negotiate a working-capital covenant because the cash conversion cycle is deteriorating.