Assessing the Debt Capacity of a Company
Debt capacity refers to an assessment of the amount of money owed that a company or individual can pay back within a specified period. Basically, it reflects a company’s ability to borrow. The level is different for various sectors and industries. It depends on the composition, type, and nature of cash flows and assets. Debt is regarded as desirable when the value of the shareholder’s equity is higher than the cost of financing. Most companies operate well and expand when their debt-to-equity ratio is 1:1 or 2:1.
Debt capacity measures the amount of money that can be borrowed without any financial problems. Interest rate fluctuations and revenue changes can affect the capacity of a business to borrow. The latter is determined by several factors, including the expendable resources-to-debt ratio, debt service-to-operations, and service coverage.
What is EBITDA
To assess their financing capacity, companies compare their debt level with their earnings before interest taxes depreciation and amortization. To illustrate, a company with EBITDA of $1.5 million has a financing capacity of $6 million. Thus, financial institutions may offer funds in the amount of 4 times the EBITDA. The existing loans are subtracted to find out the company’s additional debt capacity. While the formula looks simple, companies take different factors into account and make adjustments. For example, businesses that have significant assets should deduct from EBITDA their ongoing capital expenditures and manufacturing expenses. This is how the costs for operating and maintaining an asset are accounted for. Adjustments may be necessary if the company has non-recurring or significant expenses or revenues. These include losses or gains from the sale of equipment and buildings, bonuses, moving expenses, as well as litigation costs.
The type of debt is also taken into account when assessing a company’s financing capacity. There are different types of financial institutions and non-bank entities such as insurance funds, business development corporations, banks, credit unions, subordinated and mezzanine lenders, commercial finance businesses, and others. As a rule of thumb, non-bank entities such as operating companies offer more funds but charge higher rates of interest. The capacity of a company to borrow can be affected in times of recession and economic slowdown. Then debt multiples can drop to 3.5 or even 3.5x even for profitable businesses. Some companies face excessive and multiple debts while their EBITDA declines. This means that interest rates and the current state of the economy determine a company’s debt capacity.
There are other factors that can improve a company’s chances to find debt capital. Profitable and established businesses are offered better terms and rates than start-ups. Some businesses can offer significant collateral, including factory buildings and machinery and equipment. Financial institutions often offer large amounts of money to such businesses. Moreover, loans usually come with long periods of repayment.
In simple words, debt capacity refers to the ability to pay existing debts while taking out an additional loan. The financing capacity of a company can be bad or good. Measuring financial leverage, the debt-to-equity ratio of businesses with unused financing capacity is less than one. Financial institutions are willing to offer loans to such companies. Bad debt capacity, on the other hand, affects the ability of companies to borrow, as well as their stock price. It also indicates that a business doesn’t have sufficient cash flows for its operations and debt repayment. Companies take different approaches to increase their financing capacity. They may lower the debt-to-equity ratio and increase the amount of retained earnings. Thus, a business may reduce the dividends paid to shareholders. Other options are to issue new shares or to sell a portion of the existing assets. This is done to repay debt with high interest rates. Companies can lower interest payments by borrowing less and taking a conservative approach to cash flow and expense budgeting. Businesses can increase their financing capacity by lowering their debt levels and increasing their earnings before interest taxes depreciation and amortization.
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