Debt Capacity

The ability to take on and repay corporate debts

What is Debt Capacity?

Debt capacity refers to the total amount of debt a business can incur and repay according to the terms of the debt agreement. A business takes on debt for several reasons, such as boosting production or marketing, expanding capacity, or acquiring new businesses. However, incurring too much debt or taking on the wrong kind can result in damaging consequences.

How do lenders make decisions on which businesses to lend their money? In this article, we will explore the most commonly used financial metrics to evaluate how much leverage a business can handle. At the end of the day, lenders wish to seek comfort and confidence in lending their money to businesses that can internally generate enough earnings and cash flow to not only pay the interest, but also the principal balance.

 

Debt Capacity Matrix

Source: CFI’s free introduction to corporate finance course.

 

Assessing Debt Capacity

The two main measures to assess a company’s debt capacity are balance sheet and cash flow measures. By analyzing key metrics from the balance sheet and cash flow statements, investment bankers determine the amount of sustainable debt a company can handle in an M&A transaction.

 

EBITDA and debt capacity

The first measure to evaluate debt capacity is EBITDA, or Earnings Before Interest, Tax, Depreciation, and Amortization. To learn more about EBITDA, please see our EBITDA Guide.

The level of EBITDA is important to assess the debt capacity as companies with higher levels of EBITDA can generate more retained earnings to repay their debt. Hence, the higher the EBITDA level, the higher the debt capacity. However, although the level of EBITDA is crucial, the stability of a company’s EBITDA level is also important in assessing its debt capacity. There are a few factors that contribute to a company’s EBITDA stability: cyclicality, technology, and barriers to entry.

Cyclical businesses inherently have less debt capacity than non-cyclical businesses. For example, mining businesses are cyclical in nature due to their operations, whereas food businesses are much more stable. From a lender’s point of view, volatile EBITDA represents volatile retained earnings and ability to repay debt, hence a much higher default risk.

Industries with low barriers to entry also have less debt capacity compared to industries with high barriers to entry. For example, tech companies that have low barriers to entry can easily be disrupted as competition enters. Even if tech companies are legally protected through patents and copyrights, competition will eventually enter as the patent term expires, or with newer and more efficient innovations. On the other hand, industries with high barriers to entry, such as long-term infrastructure projects, are less likely to be disrupted by new entrants and, therefore, can sustain stable EBITDA.

Learn more in CFI’s free introduction to corporate finance course.

 

Balance Sheet Measures

Balance sheet metrics are extremely useful to determine debt capacity as they directly reflect the book values of assets, liabilities and shareholder equity. The most commonly used balance sheet measure is the debt-to-equity ratio.

 

Debt to Equity

Debt-to-equity ratios provide investment bankers a high-level overview of a company’s capital structure. However, this ratio can be complicated as there can be a discrepancy between the book and market value of equity. Acquisition adjustments to assets, goodwill and impairment are all influential factors that may create a discrepancy between the book value and market value of debt-to-equity ratios.

 

Cash Flow Metrics

Another set of measures investment bankers use to assess debt capacity is cash flow metrics. These metrics include total debt to EBITDA, which can be broken down further to senior debt to EBITDA, cash interest coverage, and EBITDA-Capital Expenditures interest coverage.

 

Total Debt / EBITDA

Debt to EBITDA measure is the most common cash flow metric to evaluate debt capacity. This ratio exhibits a company’s ability to pay off its incurred debt and provides investment bankers with information on the amount of time required to clear all debt, ignoring interests, taxes, depreciation and amortization. Total debt to EBITDA can be broken down into senior or subordinated debt to EBITDA metric, which only focuses on debt that a company must repay first in the event of a distress.

 

Cash Interest Coverage

Cash interest coverage measure depicts how many times the cash flow generated from business operations can service the interest expense on the debt. This is a key metric as it not only shows a company’s ability to pay interest but also its ability to repay principal.

Learn more in CFI’s free introduction to corporate finance course.

 

EBITDA-CapEx Interest Coverage

By taking the EBITDA and deducting capital expenditures and examining how many times this metric can cover the interest expense, investment bankers can assess a company’s debt capacity. This metric is specifically useful for companies with high capital expenditures, including manufacturing and mining.

 

Additional Resources

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