Debt capacity is an analysis conducted in determining what is the sustainable level of debt for a company.
Debt capacity is a very important concept to understand in credit. As such, debt capacity is the first thing they teach in the training manual for corporate and commercial bankers – how much debt can a company handle before they have difficulties servicing the debt and the bank’s money is lost.
Keep in mind that creditors do not get to participate in the upside of any entity that they lend to – they merely are entitled to a series of cash flows as contracted for in the debt agreement.
Calculating Debt Capacity – Leverage and Coverage
An academic approach is to see what an appropriate capital structure is and allocating a certain amount of cash flows to debt and to equity for a certain number of years (based on the life of the assets). Afterwards, the cash flows to debt are discounted by the interest rate. This is a little fluffy.
A more practical approach is to look at standard leverage and coverage multiples to ascertain an appropriate debt capacity with a reasonable cushion (for example, 25% to account for volatility in cash flows).
Debt Capacity Calculation Through Interest Coverage
As a simplification, the corporate banker looks at a required interest coverage ratio. For example, this interest coverage ratio could be 2 or 3x EBITDA. The weighted average cost of debt for the firm (Debt A x Interest A + Debt B x Interest B… all divided by the total debt of the firm) is the second component. With these two numbers, you can back out the debt capacity – which is the debt that at that interest rate would get you to the interest coverage ratio after applying a cushion.
Now in reality, the current weighted average interest may not make sense because risk free interest rates may have gone much higher or the credit quality may have deteriorated, which means the marginal cost of debt may be a more reasonable number.
Asking the DCM team for the indicative new issue cost of debt or looking at credit rating agency comps (for example other BBB rated names in the same sector with similar leverage) can guide to an approximate cost of debt.
Debt Capacity Calculation Through Leverage Multiple
Leverage ratios are usually in the form of Debt/EBITDA. Similarly, a debt capacity is backed out by getting a leverage number such as 3x, applying a cushion and multiplying the EBITDA plus cushion to get to the debt capacity.
In reality (and according to Warren Buffett), EBITDA is a nonsensical figure – so for certain industries where there are real capital requirements, unlevered free cash flow can be used instead. Recall – the formula for unlevered free cash flow is EBITDA – Tax – Capex – Change in Net Working Capital.
Then, an analyst can look at the two figures (leverage multiple debt capacity and interest coverage debt capacity) and choose the smaller of the two as a debt ceiling.
If debt is above this debt capacity, or the company is asking its bankers for money in excess of the debt capacity, the commercial banker has to provide a good reason for their credit and risk management divisions as to why the money should be provided. Reasons could include stable, long-life assets. Reasons that are not included on the page are to help the relationship to get investment banking revenues such as debt capital markets issuance.
Debt Capacity versus Enterprise Value
Now, debt capacity is always below the value of the firm or entity that is the borrower. An entity cannot be 100% financed by the banks or bondholders – this capital structure does not make sense and does not offer an attractive risk/reward profile.
Instead, debt capacity should match up with the right amount of debt in the capital structure given the future cash flows of the firm as well as providing a reasonable “cushion” for debtholders in terms of excess cash flow to service interest and principal.
Cyclicality also has to be taken into account. If a company is growing cash flows sustainably, enterprise value and debt capacity should both grow. If a company has very high EBITDA this year but the economy is in full boom mode and higher cash flow is a cyclical phenomenon as opposed to a secular trend, debt capacity should not necessarily be calculated by using this year’s cash flow. Instead, a normalized cash flow should be used in case the company is saddled with too much debt and faces a painful restructuring later when the economy slows and new cash flows cannot service interest comfortably.
If debt is above debt capacity and even above enterprise value, a right-sized entity will result in the face value of debt being extinguished and creditors losing money.