A borrower’s capacity is the borrower’s ability to make its debt payments on time and in full amount. It is one of the 5 C’s of Credit analysis, together with collateral, covenant, character, and conditions.
Factors that Affect a Borrower’s Capacity
A borrower’s ability to pay its debt obligations on time and in full amount depends on factors that are both internal and external.
The internal factors are those factors that depend on the company’s characteristics, such as its ability to generate free cash flow (FCF), the structure of its assets and liabilities, or the amount and maturity of debt on the balance sheet.
The external factors are those that depend on industry characteristics, such as the intensity of competition or the barriers to entry, and those that depend on the status of the economy, such as the phase of the business cycle or the level of interest rates.
Analyzing the Internal Factors
Analyzing the internal factors means looking at a company’s financials and ratios, competitive position, capital structure, strategy, and execution. Each of the areas is analyzed via several indicators.
For example, the analysis of a company’s competitive position includes but is not limited to, the analysis of its market share, brand power, pricing power over supplier and customers, and differentiation of its product.
Financials and Ratios Analysis
The analysis of a company’s financials and ratios generally involves:
1. Profitability and cash flow ratios
The analysis generally focuses on metrics such as profitability margins, return on invested capital, and FCF margins. A company’s ability to settle its debt obligations will depend on its ability to generate enough cash. The analysis of FCF and margins allows analysts to understand better whether a company is likely going to generate enough resources to pay back its debt.
The more leveraged a company is, the more difficult it will find to face its debt obligations timely and in full amount. The analysis of leverage ratios generally includes debt/capital, debt/equity, FCF/debt, and net debt/EBITDA, to name a few.
3. Coverage ratios
How much principal a company needs to pay back is not the only problem in the assessment of whether a company can face its obligations. The interest charged is not the same for each company, and it significantly impacts a borrower’s capacity. That’s why the analysis of coverage ratios, such as EBITDA/Interest expense and EBIT/Interest expense, is extremely important.
Analysts need to assess a company’s competitive position through the analysis of several factors, such as the company’s brand power, market share, the level of differentiation of its offerings versus its peers, and the pricing power of a company versus its suppliers and customers.
A company with a strong competitive position will likely be able to keep profitability and FCF higher than one with a poorer competitive position.
Moreover, a strong competitive position may allow the company to enjoy more flexibility with suppliers and implement stricter practices with customers, which would ultimately benefit the company’s working capital and improve its capacity.
Management Strategy and Execution
A proper analysis of the management’s strategy and track record is also necessary. For example, it is important to understand the following:
Whether the management is pursuing long-term value creation or short-term goals that can hurt the company in the long term while assessing whether there are proper incentives for value creation in place.
Whether the strategy is aggressive or too risky, as it would be in the case of an aggressive debt-financed acquisition strategy with limited strategic value.
Whether the sources of capital used are appropriate for the company’s goals and whether there is an excessive reliance on debt versus equity.
Whether the strategy is consistent with the company’s strength or whether the company is chasing expansion in areas where it has low chances of adding value.
External Factors and Borrower’s Capacity
Some factors that affect a borrower’s capacity are external and, therefore, have little to do with the specific characteristics of the company. The external factors include:
1. Industry structure
Industry structure must be analyzed by assessing the number of competitors, the barriers to entry and exit, the power of customers and suppliers, and the threat of substitute products. Such analysis can be done based on useful frameworks such as Michael Porter’s Five Forces.
2. Industry cyclicality
Cyclical industries generally experience more volatile revenue, margins, and FCF, as their performance largely depends on the business cycle and the state of the overall economy. The level of cyclicality in the industry must be assessed, as cyclical industries are generally riskier than non-cyclical ones.
3. Growth prospects in the industry
While strong growth in an industry can generally act as a rising tide that lifts all the boats, scarce or negative growth prospects in an industry can be more problematic for companies that need to pay back some debt. Weaker competitors can struggle and experience a deterioration of their capacity.
4. Macroeconomic conditions
The state of the overall economy can significantly impact a borrower’s capacity. GDP growth, the level of interest rates, and currency volatility are clear examples of factors that can affect a company’s ability to pay back its debt obligations.
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