What is “Debt Capacity”?
Debt capacity refers to the capacity of a company to take on debt or the total amount of debt it can incur to finance purchase of assets, invest in business operations, increase return on investment, boost production etc. and repay lenders (according to terms of the debt agreement). The balance sheet and cash flow statements are two key measures to assess a company’s debt capacity.
The most common cash flow metric used to assess the debt capacity of a company is the Debt to EBITDA Ratio. The logic behind this ratio is that for a given amount of debt in the numerator, the EBITDA divided into this amount tells us approximately how many years would it take a company to pay back the debt.
Key Learning Points
- If a company has a higher EBITDA level, then its debt capacity also tends to be higher;
- A company that has an increasing Debt/EBITDA ratio overtime, will find it more difficult to repay its debts, as this indicates that its debt is rising faster than earnings;
- Debt capacity analysis informs lenders of how much additional leverage can be supported by a company;
- An increase in leverage in adverse economic conditions will result in the downgrade of a company’s investment grade rating; and
- Debt capacity of a company can be assessed by the Cash-Flow based Debt Capacity.
Debt to EBITDA
The formula for Debt to EBITDA is:
Debt to EBITDA Ratio = Debt (Short Term + Long Term)/EBITDA
EBITDA refers to earnings before interest, taxes, depreciation and amortization.
Generally, the higher the EBITDA level of a company, the higher is its debt capacity. However, in assessing the debt capacity of a company, the stability of its EBITDA needs to be considered. EBITDA is only an approximation for cash and this Debt/EBITDA multiple can be misleading.
Generally, if a company has an increasing Debt/EBITDA ratio overtime, it implies that its debt is rising faster than earnings. Therefore, the company will find it more difficult to repay its debts.
Assessing Debt Capacity – Importance
The debt capacity of a company informs us about how much additional leverage can be supported by the company, if it is considering a potential strategic acquisition or leveraged buyout (LBO). Further, when stock prices are low, the management of a company can go in for a large buy back of its stocks. Consequently, it may want to borrow money for this purpose.
The debt capacity of a company provides creditors with information about how much capacity it has to weather a cyclical or seasonal downturn.
Creditors are concerned about the incremental leverage that a company can handle in such adverse conditions and how much of an increase in the same will result in the downgrade of its investment grade rating. Further, creditors want to know how much leverage will result in the collapse of a company.
Cash Flow Based Debt Capacity
Cash-flow based debt capacity is a way to assess the debt capacity of a company. Given below is a workout. Cash flow based capacity lending is predicated on the free cash flows (FCF) forecast and current interest rates.
The first step is to obtain free cash flow (FCF) of a company. Most bank analysis is done on specific cash flow metrics, such as FCF, which tells a bank exactly how much cash is available for a company to repay its debt after all necessary expenses are made.
FCF formula:
FCF = EDITDA – Interest – Taxes +/- working capital +/- other operational liabilities – capital expenditure
All these expenses must be paid before it can be determined if the company has room for additional leverage. Once the FCF is calculated, the cash-flow based debt capacity computations can be done. The amount of debt that a company can handle and pay back is based on each year’s cash flow.
Assume, the following FCF forecasts from Year 1 to 5. Further, to calculate the debt capacity of a company using the cash flows, the sum of the free cash flows is discounted each year by the after-tax cost of debt (5%). This is also called the NPV or Net Present Value (NPV = SUM OF FCF (Year 1 to 5), After Tax Cost of Debt), which here is 479.7.
Next, calculate the interest in each year – based on the outstanding balance multiplied by the after -tax cost of debt. Further, the debt repayment each year is computed as FCF that year – the interest paid in that year. By the end of 5 years (i.e. end of the term loan), the debt is paid off, assuming all cash flows are used.
