Download our free Debt Capacity Analysis Template and gain mastery over this critical financial metric. This comprehensive template will guide you through calculating a company’s debt capacity, helping you make informed decisions about leverage and financial strategy.

What is Debt Capacity?

Debt capacity refers to the total amount of debt a company can incur to finance its operations, purchase assets, or invest in growth opportunities while still being able to repay lenders according to the terms of the debt agreement. It is a critical measure of a company’s financial health and flexibility.

The debt capacity will be determined by company management and benchmarked by those prepared to lend to the company. It is driven by the operating performance. Generating consistent EBITDA and reliable cash flows from operations will clarify the level of debt that a company is prepared to take on. If operations are perceived to be volatile or risky (due to market conditions or company specific reasons) then the debt covenants may be more restrictive to reflect this.

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The Debt to EBITDA Ratio Explained

The Debt to EBITDA ratio is calculated as:

Where EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.

This ratio estimates how many years it would take a company to pay back its debt using its EBITDA. Generally, a higher EBITDA suggests a higher debt capacity, but it’s fundamental to consider the stability of EBITDA over time.

Cash Flow-Based Debt Capacity

A more in-depth approach to further assessing debt capacity involves analyzing a company’s free cash flow (FCF). This method considers:

By projecting FCF and discounting it using the after-tax cost of debt, analysts can estimate a company’s debt capacity more accurately. Future cash flows will be used to service the interest payments and determine the strength of the company’s ability to repay the debt within a period of time.

Debt capacity can be influenced by a series of factors, ranging from the market (or industry) that a company operates in, to the individual performance and positioning of the company within that sector. It is determined by management and will examine historical and future performance, focusing on the strength of the EBITDA and cash flows generated from the core business. Using ratios to analyze this, relative to both past performance and also peer group performance, is integral to investors.