This Debt Capacity Model Template will help you assess the debt capacity based on various credit metrics and current earnings.
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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.
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.
The two main measures to assess a company’s debt capacity are its 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.
Some important credit metrics to measure in assessing debt capacity:
Debt-to-equity ratios provide investment bankers a high-level overview of a company’s capital structure.
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.
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 interest, taxes, depreciation, and amortization.
The cash interest coverage measure depicts how many times the cash flow generated from business operations can service the interest expense on the debt.
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.
The fixed charge coverage ratio is equal to a company’s EBITDA – capex – cash taxes – distributions.
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