Most businesses will eventually need to borrow money or enter into a lease agreement. Whether it’s venture capital to get new technology off the ground or a lease for office equipment, financial transactions like these happen.
There’s nothing wrong with this – it’s a standard course of business in many industries. In fact, some industries thrive on utilizing their debt efficiently to make the most of their cash flow.
But how does a company determine its own debt capacity? And how can debt capacity be calculated when reviewing financials for another company?
This blog will look at the finer points of debt capacity, how it impacts a business’s ability to participate in credit-based transactions, and how much debt a company should take on without causing instability.
What is Debt Capacity?
Debt capacity is the ability of a business (or individual in the case of a sole proprietorship) to meet its financial obligations when they are due without causing insolvency. Effectively, it’s the amount a business can borrow without putting the company in a financially bad situation. Debt capacity is an effective tool in determining a company’s creditworthiness and ability to repay debt.
In fact, debt capacity models and debt capacity templates are often used internally by businesses to set their standards for debt limits. Some businesses, for example, may limit their debt to 5% of their earnings.
Other companies, like lenders, use debt capacity models and templates to determine whether or not they want to work with another company. It may be used in conjunction with a credit report from a national bureau, or it may be used as a standalone assessment.
Debt Capacity Formula
The reality is that most companies that analyze debt capacity calculate it a bit differently. Dozens of formulas may be used to get a picture of a company’s debt capacity. Some important formulas to consider are:
- Current ratio: The current ratio, which is the current assets divided by the current liabilities, lets a company know how well current bills are paid. Also called the “working capital” ratio, it shows a company’s ability to pay short-term debts. A higher ratio indicates better repayment ability.
- Debt service coverage ratio: A higher debt service coverage ratio (DSCR), or times-interest-earned ratio, indicates that a company has a solid repayment and debt capacity. The DSCR is net operating income as a multiple of obligations and liabilities due within the next year, including interest, lease payments, principal, and sinking-fund.
- Debt to total asset ratio: This ratio takes total debt divided by total assets to assess how much of a company’s assets are available and not tied to debt. In this case, the higher the ratio is, the higher the financial risk. This is different from other ratios in that it considers intangible assets.
These are just a few debt capacity formulas that can be useful in determining a business’s ability to either meet its current outstanding obligations or take on new debt. To get a better picture of a company’s financial health, however, a more robust dive into financials should be taken.
Calculating Debt Capacity - The Numbers
Debt capacity formulas are relatively simple formulas that, when combined, form a more complex debt capacity calculation. The debt capacity calculation may be based on stipulations in a company’s articles of association or articles of incorporation. Those stipulations may limit the amount of debt a company can take on.
More complex debt capacity models will look at the historical debt capacity of a company and forecast unused debt capacity so businesses are able to plan for purchases that may require financial services. Basic debt capacity models will look at the debts and liabilities of a company as well as their earnings and any other income.
What is Unused Debt Capacity?
A company’s unused debt capacity is effectively how much debt capacity they have available should they need to borrow money or enter into a financial transaction. Companies that have adequate unused debt capacity will have access to more capital, possibly at a lower cost to them.
Typically, a company with a “good” unused debt capacity will have a debt to equity ratio of less than one, meaning they have easier access to money. A debt to equity ratio that is greater than one means that a business is likely to have harder access to funds.
Debt capacity is a complex subject that requires a bit of diligence. There are a number of terms and situations that can complicate the debt capacity formula. These are a few questions commonly asked about debt capacity and how it impacts a company.
What is Insufficient Debt Capacity?
Insufficient debt capacity is a company’s lack of sufficient cash flow to cover any additional debts or liabilities. Companies with insufficient debt capacity will have a difficult time getting access to capital and any capital they may receive will likely have a higher cost than for firms with sufficient debt capacity.
The best way to improve debt capacity is to improve cash flows and reduce debts and liabilities, either through paying them off or down. Otherwise, the company may be considered high risk and have few borrowing options in the future.
What Indicates That a Company is in Debt?
After a thorough assessment of a company’s financial statements, it should be relatively easy to tell if a company is in debt. The debt ratio is a calculation of total debt to total assets, usually expressed as a decimal or percentage.
Companies that have a ratio that is greater than one have a substantial amount of debt and may be at high risk of default or insolvency. Companies with a ratio of less than one have less debt and a better financial profile for lending.
What is Debt to EBITDA?
EBITDA, or “earnings before interest, taxes, depreciation, and amortization”, is used to determine a company’s financial performance. It’s effectively the cash flow for the business but excludes things like capital structure, debt financing, methods of depreciation, and taxes.
The formula for EBITDA is operating profit + depreciation + amortization. It’s useful for evaluating companies that haven’t turned a profit, as it gives a picture of a company’s cash flow. It’s also a good measure of comparing performance against competitors.
Debt to EBITDA is a comparison of how much debt a company has to how much “cash flow” it effectively has. However, the stability of a company’s EBITDA is more important than just an initial picture of their earnings. Stability can be determined by barriers to entry, cyclicality, and technology.
How Much Debt Should a Company Take On?
The first thing to make clear is that this varies greatly based on many factors, such as things like industry, size of the business, location, and differentiating factors. How much debt a lender thinks a business should take on will vary greatly from business to business, as well.
There are, however, some ways to assess how much debt a company has, how much debt is too much debt, and how much debt a company can take on without reneging on its financial obligations.
Here are some useful calculations for determining how much debt a company should take on:
- Debt to equity ratio: Also called the “risk ratio” or “gearing”, the debt to equity ratio is a calculation of the total debt and liabilities against the shareholders’ equity. This differs in the debt to asset ratio in that the denominator is equity instead of assets. The formula for the debt to equity ratio is short term debt + long term debt + other fixed payments divided by shareholder’s equity. Something to note is that these calculations can be misleading as there are factors that create discrepancies between the book and market value of the debt to equity ratio.
- Capacity to repay debt: The capacity to repay debt is the ability a company has to meet its financial obligations when they are due – a business with a high capacity to repay debt has adequate funds to cover its debts in a timely manner, whereas a business with a low capacity to repay debt will have a harder time meeting its financial obligations. Reducing debt and increasing cash flows is the best way to increase a company’s capacity to repay debt.
How much debt a company should take on will depend on each company’s unique situation. Use the debt to equity ratio to get a general idea of how much debt a company can take on, then use financial statements to evaluate the company’s capacity to repay debt.
Debt Capacity Template
A debt capacity template is a complex financial document typically put together in a spreadsheet with calculations and formulas that give the overall financial health of a company. Debt capacity templates pull from debt formulas and debt calculations to put together a comprehensive overview of exactly how much debt a company has and how much debt it can take on.
Some factors that are included in a debt capacity template are:
- Types of debt and current capital structure
- EBITDA plus the ability to pay interest expenses
- Size of the business
- Industry (cyclical or stable)
- Credit rating
- State of the credit market
A solid debt capacity template will use formulas like the current ratio, debt service coverage ratio, debt to equity ratio, and debt to total asset ratio. It will take into account tangible and intangible assets, short-term and long-term debts and obligations, as well as all shareholder equity and liabilities.
Putting it All Together
With all of the information provided in this guide, debt capacity can feel a little overwhelming at first glance. Fortunately, there are a few key takeaways that can make figuring out debt capacity a breeze:
- Debt capacity can be calculated in a number of ways, but it primarily focuses on a company’s debt compared to its ability to repay its financial obligations.
- Debt capacity formulas are useful on their own to give a quick snapshot of a company’s financial health, but they work best when used in combination with other formulas.
- Debt capacity models and debt capacity templates offer the most comprehensive view of a company’s financial position and its financial obligations.
Small businesses can start off using simple calculations and formulas to get an idea of their debt capacity, and as a company grows it can build out a more complex debt capacity model that can be used to guide financial decisions in the future.
Companies that analyze financial statements to make credit decisions will want to know a company’s financial plans, so having that information together already can make obtaining credit much less painful. Whatever a company’s plans, use this guide as a reference to put together a debt capacity model that reflects the company’s financial future.