What is Debt Capacity?
Debt Capacity is defined as the maximum amount of leverage that a company could afford to incur, determined by its free cash flow (FCF) profile and market positioning.
Debt Capacity: Definition in Lending Agreements
A company’s debt capacity, or “borrowing capacity”, establishes a ceiling on the total amount of debt that a company could take on without being at risk of default.
Debt financing can be beneficial – e.g. the lower cost of debt vs. equity and the interest tax shield – yet too much dependence on debt to fund working capital and capital expenditures (PP&E) can result in bankruptcy.
Therefore, prior to using debt, a company must estimate its debt capacity, which is the debt burden that its cash flows can realistically handle, even through a performance decline.
Debt Capacity Determinants
The more predictable the company’s free cash flows, the greater its debt capacity will be – all else being equal.
The degree of risk associated with the industry is typically the starting point for assessing a prospective borrower.
Of the various metrics and risks considered, some of the most important ones are the following:
- Industry Growth Rate – Stable historical and projected industry growth is preferred (e.g. CAGR)
- Cyclicality – Fluctuating financial performance based on the prevailing economic conditions
- Seasonality – Predictable recurring patterns in financial performance throughout the fiscal year
- Barriers to Entry – The more difficult it is for new entrants to capture market share, the better
- Disruption Risk – Industries prone to technological disruption are less attractive for lenders
- Regulatory Risk – Changes in regulations have the potential to change the industry landscape
Once the industry has been assessed, the next step is to gauge the company’s competitive position in the market.
Here, the objective is to understand the following:
- Market Positioning: “How does the company compare to the rest of the market?”
- Competitive Advantage: “Is the company actually differentiated from competitors?”
Over the long-run, a company that is not differentiated is at risk of underperformance losing market share from the emergence of a better and/or cheaper alternative appearing in the market (i.e. substitution risk).
However, a company with an “economic moat” is differentiated with unique attributes that can help protect its long-term profits.
Lender Model: Credit and Default Risk Analysis
Creditors incrementally adjust an operating and leverage model assumptions to determine if the company can weather downturns and adverse financial conditions.
Lenders are sent projection models by companies, typically on the conservative side compared to those sent to investors, which helps strike a balance between appearing irrationally optimistic or too risky of a borrower.
Provided with the financials and supporting documents from the borrower, lenders create their internal model that focuses primarily on the downside scenarios. To reiterate from earlier, lenders seek to provide debt to companies with predictable, steady free cash flows.
Found within lender models are detailed scenario analyses that calculate the approximate debt capacity of the company.
Under different operating cases, the company’s credit ratios are tracked to quantify how much of a decline in performance causes the default risk to be too substantial. For instance, the lender model could calculate the leverage ratio if assuming the company’s EBITDA were to suffer a 20-25% drop.
Lender Credit Ratio Examples
|Total Leverage Ratio||
|Senior Debt Ratio||
|Net Debt Leverage Ratio||
|Interest Coverage Ratio||
The parameters set on the total leverage amounts and interest coverage parameters vary significantly based on the company’s industry and the prevailing lending environment (i.e. interest rates, credit market conditions).
By the end of the lender’s analysis, the implied leverage ratio is presented to the borrower alongside the preliminary pricing terms (e.g. interest rate, mandatory amortization, term length) – but the terms are subject to change post-negotiation.
In particular, the debt capacity is the basis for how debt covenants are set. The riskier the borrower’s credit profile, the more restrictive the covenants are going to be to protect the lender’s interests.
Note that the debt capacity is not necessarily the maximum amount of debt that can be raised, due to the inclusion of an extra “cushion” to ensure all debt obligations are met.
Leverage Risk and Debt Capacity Considerations
Generally, a company strives to derive as many benefits as possible from debt financing without endangering the company and putting it at risk of default.
Increased leverage means reduced dilution in equity ownership and greater potential returns for shareholders. Yet, companies typically raise less leverage than their full debt capacity.
One potential explanation is that the company could be uncertain whether it can support the additional debt or have opportunities to utilize the proceeds from the debt funding profitably.
In closing, the debt capacity is a function of the company’s fundamentals, historical (and projected) financial performance, and industry risks. However, the amount of debt raised as a percentage of the total debt capacity is a management judgment call.