The economy is booming, but the future direction of interest rates is unclear. Companies need to seize the moment to position themselves for growth. But smaller companies may lack confidence in their ability to understand the lending process and position their company for the best deal.
What are the factors involved in analyzing how much debt you can take on, and what do you do with the information once you have it?
What Is Debt Capacity?
Debt capacity refers to the amount that a company can reasonably borrow and pay back within a specified time period. A customized debt capacity can help a company test the feasibility of their expansion plans, acquisition capabilities or capex needs. In theory this is the amount that a company should be able to borrow.
In measuring debt capacity, a common approach is to compare the amount borrowed to the company’s earnings before interest, taxes, depreciation and amortization (EBITDA).
With the help of their banker, businesses can educate themselves on the amount of debt their cash flow and balance sheet might support and what to expect when they request financing from a bank.
Key Metrics - Definitions
- Key metrics from the company’s financial statements are also often used to determine debt capacity. Some of these ratios include:
- Total debt to EBITDA is a common ratio measuring the company’s ability to service its debt before deducting interest, taxes, depreciation and amortization.
- Debt to equity is an important balance sheet ratio that provides lenders with a high-level overview of the company’s capital structure.
- Cash interest coverage shows how many times cash flow from operations covers the company’s interest expense on its debt.
- The fixed charge coverage ratio is commonly calculated by dividing the company’s EBITDA by its fixed charges. Fixed charges are typically defined as the company’s current maturities of long-term debt, interest, taxes, distributions and unfunded capital expenditures. This ratio is considered to be a true measurement of a company’s cash flow and an important indicator of debt capacity.
There are no hard-and-fast rules on exact acceptable levels for any of the indicators, but when looked at together, they paint a good picture of a company’s debt capacity and of its ability to service current and potential future levels of debt. It’s meaningful to compare these ratios against other companies in the same or similar industries.
Effect of Stability on Debt Capacity
Lenders like to see stability of revenue, earnings and cash flow in determining how much debt to extend to a company.
- Cyclical businesses generally have less debt capacity than businesses with more steady revenues, earnings and cash flow.
- Industries with low barriers to entry tend to have less debt capacity as well. New competitors can enter and take market share from more established companies, making their earnings and cash flows less predictable.
It’s important to note that a company’s debt capacity might also be constrained by covenants on existing debt that place limits on ratios like the ones discussed above or other key metrics surrounding the level of total debt.
The Importance of Understanding Your Debt Capacity
Understanding your company’s debt capacity is very important for planning purposes. Expanding your business, making a strategic acquisition and financing continuing operations all take capital. Knowing the level of debt that your company can reasonably take on allows you to effectively plan around how your company will meet its financing needs.
Having available borrowing capacity allows your company to take advantage of favorable interest rates when they are available. It also provides financing options that allow you to take advantage of the most favorable alternative, whether additional debt or raising additional equity.
How Much Should I Borrow?
Like many other things in business and life, just because someone will lend your company $X doesn’t mean that’s the right amount to borrow. The question of how much to borrow will vary with each situation. At the end of the day, debt requires interest payments and the ultimate repayment of the amount borrowed.
The appropriate amount to borrow should be part of larger questions like:
- What is the optimal capital structure for our company?
- What is our most cost-effective source of funds?
Use of Leverage
Debt creates leverage for a company. Financial leverage relates to the use of debt to finance the business. Leverage allows the business to use less of its own cash flow to purchase assets and finance its operating needs. Leverage can magnify the company’s returns on assets when the business is profitable and growing. It can also magnify the impact of losses in that interest payments still need to be made and the loan needs to be repaid regardless of the company’s financial situation.
Using some hypothetical examples might help illustrate the concept of debt capacity and using the right type of loan to meet your company’s needs.
- A manufacturer might consider a loan to finance equipment needed to expand their production. If the company has sufficient debt capacity, strong cash flows and solid credit, they might consider a loan based on the company’s cash flow. However, if their EBITDA margin is relatively low, the company might be a candidate for an asset-based loan backed by the equipment they are purchasing as collateral.
- A life sciences company looking to purchase a competitor might finance the acquisition via a traditional cash flow or asset-based loan if they have the debt capacity. Other options might include more creative options such as senior secured debt or second lien financing.The pro-forma combined financialThe pro-forma combined financial position of the new company formed by this combination will help determine how to finance the transaction as well.
- A growing technology company needs to secure funding to continue to finance its research and product development efforts. Depending upon the nature of the company, a conventional cash flow–based loan might fit the bill if the company is generating profits and cash flow and has sufficient debt capacity. If this is not the case, a more creative solution might need to be found.
Debt creates leverage for a company. Financial leverage relates to the use of debt to finance the business. Leverage allows the business to use less of its own cash flow to purchase assets and finance its operating needs. Leverage can magnify the company’s returns on assets when the business is profitable and growing.
Ready To Help
Your PNC Relationship Manager can work with you to understand your objectives and collaborate with you in the evaluation process so that, at the end of the day, you can be confident in requesting and utilizing the right amount and type of financing to help your business prosper.