Downside Modeling Example: TechFlow Distribution

Transaction Context

Company: TechFlow Distribution, Inc.

Industry: Technology equipment distributor serving enterprise customers

Proposed Transaction: $75 million senior secured term loan to refinance existing debt and fund working capital

Use of Proceeds: $60M debt refinancing, $10M working capital, $5M transaction fees

Your Role: Credit analyst at a regional bank evaluating this lending opportunity

Current Financial Profile

Annual Revenue

$320M

EBITDA

$28M

EBITDA Margin

8.8%

Total Debt (Proposed)

$75M

Cash Balance

$8M

Leverage Ratio

2.7x

Additional Metrics	Value	Notes
Interest Coverage	4.2x	Based on 6.5% interest rate ($4.9M annual interest)
Revenue Growth (3yr avg)	7.5%	Consistent but moderate growth
Customer Concentration	Top 10: 42%	Moderate concentration risk
Working Capital	$45M	14% of revenue
CapEx	$3.2M annually	1% of revenue (asset-light model)

1Identify Stress Drivers

Key Vulnerability Assessment

Based on industry analysis and company-specific factors, we identify the primary stress drivers:

Revenue Pressure: Technology refresh cycles create volatility; enterprise IT budget cuts during recessions
Margin Compression: Vendor price increases that cannot be fully passed through; competitive pricing pressure
Working Capital Strain: Extended payment terms during customer stress; inventory obsolescence risk
Customer Concentration: Loss of major customer would significantly impact revenue
Cyclical Exposure: High correlation with corporate capital expenditure cycles

2Define Downside Scenarios

Moderate Downside Scenario

Probability: ~25-30% over loan life | Timeframe: Year 2 of loan

Economic Context: Mild recession with 1-2 quarter GDP contraction, corporate IT spending down 8-12%

Assumption	Impact	Rationale
Revenue Decline	-12%	Historical performance during 2015-2016 tech spending slowdown
Gross Margin	-80 bps	Competitive pricing to retain volume; vendor price pressure
Operating Expenses	-6%	Partial cost reductions (headcount, discretionary spend)
Working Capital	+5% of revenue	Extended DSO as customers delay payments

Severe Downside Scenario

Probability: ~10-15% over loan life | Timeframe: Year 2-3 of loan

Economic Context: Severe recession similar to 2008-2009; prolonged IT spending freeze; loss of top customer

Assumption	Impact	Rationale
Revenue Decline	-22%	2008-2009 downturn saw 18-25% declines in tech distribution; includes customer loss
Gross Margin	-150 bps	Severe pricing pressure; inventory markdowns; unfavorable vendor terms
Operating Expenses	-10%	Aggressive cost cuts, but fixed cost base limits reductions
Working Capital	+8% of revenue	Significant DSO extension; elevated inventory due to demand shock
One-Time Costs	$2.5M	Restructuring and severance costs

3Project Financial Performance

Base Case (Management Projection)

Revenue: $320M → $342M (7% growth) Gross Profit: $51.2M → $55.1M (16.0% → 16.1% margin) OpEx: $23.2M → $24.0M EBITDA: $28.0M → $31.1M (8.8% → 9.1% margin)

Moderate Downside Projection

Revenue: $320M → $281.6M (-12%) Gross Profit: $51.2M → $42.0M (16.0% → 14.9% margin) OpEx: $23.2M → $21.8M (-6%) EBITDA: $28.0M → $20.2M (8.8% → 7.2% margin) Decline: -28% EBITDA reduction

Severe Downside Projection

Revenue: $320M → $249.6M (-22%) Gross Profit: $51.2M → $36.2M (16.0% → 14.5% margin) OpEx: $23.2M → $20.9M (-10%) One-Time Costs: $2.5M EBITDA: $28.0M → $12.8M (8.8% → 5.1% margin) Decline: -54% EBITDA reduction

4Calculate Credit Metrics

Metric	Base Case	Moderate Downside	Severe Downside	Covenant/Target
Total Leverage	2.4x	3.7x	5.9x	Max 4.0x
Interest Coverage	6.3x	4.1x	2.6x	Min 3.0x
FCF After Debt Service	$21.2M	$10.1M	($2.4M)	Positive
EBITDA	$31.1M	$20.2M	$12.8M	N/A

Severe Downside Calculations: Total Debt: $75M (no paydown due to FCF pressure) EBITDA: $12.8M Leverage: $75M / $12.8M = 5.9x Interest Expense: $75M × 6.5% = $4.9M Interest Coverage: $12.8M / $4.9M = 2.6x Cash Flow Calc: EBITDA: $12.8M CapEx: ($3.2M) Working Capital: ($20.0M) [8% of revenue = $20M outflow] Cash Taxes: ($1.0M) Cash Interest: ($4.9M) One-Time Costs: ($2.5M) Free Cash Flow: ($2.4M) ← Negative FCF

5Assess Liquidity

Liquidity Analysis Under Stress

Source	Base Case	Moderate Downside	Severe Downside
Beginning Cash	$8.0M	$8.0M	$8.0M
Operating Cash Flow	$26.1M	$15.3M	$8.8M
Working Capital Use	($3.2M)	($14.1M)	($20.0M)
CapEx	($3.2M)	($2.5M)	($3.2M)
Debt Service	($5.0M)	($5.0M)	($5.0M)
Ending Cash	$22.7M	$1.7M	($11.4M)
Revolver Availability	$15.0M	$8.0M	$3.0M
Total Liquidity	$37.7M	$9.7M	($8.4M)

Key Finding: Severe downside creates liquidity crisis requiring additional capital or covenant relief.

6Evaluate Recovery/Collateral

Asset Valuation Under Stress

Asset Category	Book Value	Orderly Liquidation	Forced Liquidation	% of Book
Cash	$1.7M	$1.7M	$1.7M	100%
Accounts Receivable	$52.0M	$44.2M	$36.4M	70%
Inventory	$38.0M	$22.8M	$15.2M	40%
PP&E	$6.5M	$3.3M	$1.6M	25%
Total Collateral	$98.2M	$72.0M	$54.9M	56%

Recovery Analysis: Orderly Liquidation Value: $72.0M Senior Secured Debt: $75.0M Collateral Coverage: 96% (0.96x) Forced Liquidation Value: $54.9M Recovery Rate: 73% ($54.9M / $75M) Expected Loss: 27% or $20.1M Note: Tech inventory has high obsolescence risk in distress scenarios

7Covenant Compliance Testing

Covenant	Required	Base Case	Moderate	Severe
Max Total Leverage	≤ 4.0x	2.4x ✓	3.7x ✓	5.9x ✗
Min Interest Coverage	≥ 3.0x	6.3x ✓	4.1x ✓	2.6x ✗
Min Fixed Charge Coverage	≥ 1.1x	3.8x ✓	1.9x ✓	0.7x ✗
Max CapEx	≤ $5.0M	$3.2M ✓	$2.5M ✓	$3.2M ✓

Covenant Breach Analysis: Severe downside triggers multiple covenant violations in Year 2, requiring either amendment/waiver or potential acceleration of debt.

8Risk Assessment & Conclusions

Summary of Findings

Moderate Downside Performance:

Maintains covenant compliance with adequate cushion
Positive free cash flow of $10M supports debt service
Liquidity tight but manageable with $9.7M available
Leverage elevated at 3.7x but within acceptable range

Severe Downside Vulnerabilities:

Multiple covenant breaches (leverage, coverage ratios)
Negative free cash flow requires external financing
Liquidity deficit of $8.4M creates refinancing risk
Recovery rate of 73% indicates 27% potential loss exposure

Credit Decision Implications

Recommended Structure Modifications:

Reduce Leverage: Lower loan size to $65M (2.3x base, 5.1x severe) to improve downside metrics
Covenant Cushion: Set max leverage at 3.75x (allows some deterioration before breach)
Revolver Commitment: Increase from $15M to $20M to provide liquidity buffer
Amortization: Require 5% annual principal paydown to reduce exposure
Pricing: Add 50bps margin increase (to 7.0% total) to compensate for tail risk

Required Protections:

Quarterly financial reporting with covenant testing
First-priority lien on all assets (AR, inventory, equipment)
Restricted payments/dividends during covenant stress periods
Material adverse change representations
Customer concentration monitoring (quarterly top 10 report)

Final Credit Recommendation

APPROVE with Modifications

The downside modeling reveals that while TechFlow can sustain moderate stress, severe scenarios create unacceptable risk under the proposed $75M structure. The analysis supports approval with the following conditions:

Loan Amount: Reduce to $65M to improve leverage and coverage metrics
Pricing: SOFR + 450bps (50bps higher than requested) to reflect downside risk
Covenants: Max leverage 3.75x, min interest coverage 3.0x tested quarterly
Amortization: 5% annual mandatory repayment starting Year 2
Revolver: $20M commitment (up from $15M proposed)

Risk Rating: BB+ / Pass with monitoring

Expected Loss: 0.8% (10% PD × 27% LGD × 30% severe scenario probability)

Return on Risk Capital: 14.2% (acceptable for risk profile)

The modified structure provides adequate protection against moderate stress while limiting severe downside exposure through enhanced covenants, amortization, and collateral coverage. Quarterly monitoring will enable early intervention if performance deteriorates.

Downside ModelingWalkthrough Example