Debt Capacity

What Is Debt Capacity?

It is a company's choice to take on leverage. There are multiple factors that companies have to consider when deciding how much to leverage themselves.

It is essential that borrowers fully consider the decision to ensure that the company can pay off its liabilities. This is known as assessing debt capacity. Companies have to consider the industry standard level of leverage accepted by creditors, and they also have to consider the company's earnings and growth.

There are multiple ratios used by both creditors and firms that give insight into a firm's capital structure and ability to pay off its liabilities in case of an economic downturn or bankruptcy.

Those ratios and metrics are:

1. Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
2. Debt-to-Equity Ratio (D/E)
3. Debt Ratio
4. Shareholder Equity Ratio
5. Interest Coverage Ratio

Some creditors prefer companies with less leverage since it reduces the risk of bankruptcy.

However, the direct nature of the relationship between risk and reward in finance suggests that some investors prefer more risk for a potentially higher reward. The firm's goal in leveraging itself is to increase its value while keeping its bondholders and shareholders satisfied.

The ratios can be interpreted differently depending on the industry and the company in question. However, the general rule is that companies with more debt are riskier.

Understanding Debt Capacity

A company's borrowing capacity is the level of leverage a company can afford to take on without default risk. This concept is related to capital structure and a firm's choice of how to raise funds for future projects.

A company can finance its activities using retained earnings, bonds, or stocks. Leveraging is financially beneficial to firms, and there are multiple ways to assess their capacity.

However, too much leverage increases the company's risk of bankruptcy and inability to pay off its liabilities. Companies' main benefit to leveraging themselves is the "interest tax shield."

This concept occurs due to interest on debt being tax-deductible. Therefore, corporations pay lower income taxes to the government and hold more capital.

Likewise, companies may choose to issue bonds to finance their activities because it allows them to use bondholders' money instead of the company's for financing.

However, taking on too much leverage can increase a company's risk of bankruptcy, which looks unattractive to lenders.

This can cause lending to be more expensive and unprofitable. That is why companies need to assess their ability to take on leverage to decide how much debt would be most beneficial.

"A firm's leverage capacity can be measured using different assessment ratios. Meanwhile, the first indicators of the risk of default include:

• Industry Cyclicality: Cyclicality in revenue signals volatile returns to lenders, which puts the company at risk of default. An example of cyclical industries includes tourism and other seasonal industries.
• Barriers to entry: Additionally, industries with low barriers to entry and that are subject to disruption, such as the tech industry, are thought to have a higher risk of default due to their competitive and innovative nature.
• Growth rate: Lastly, the industry's growth rate indicates to investors the company's ability to grow and that it has no problem paying back its liabilities.

EBITDA and Debt Capacity

A company's EBITDA is its earnings before interest, tax, depreciation, and amortization. It is provided on the company's income statement.

It is considered important when valuing a firm's leverage capacity because its ability to generate high earnings corresponds to its ability to pay off its liabilities. Hence, the higher the company's EBITDA is, the higher its leverage capacity.

However, the stability of a company's EBITDA is also an essential factor. The characteristics mentioned above of industry cyclicality, barriers to entry, and growth rate can suggest the EBITDA stability of individual companies in the industry.

Therefore, a high and stable EBITDA shows confidence that the firm can pay its bondholders. However, an unstable and low one gives a bad signal to the market and shows less confidence that the company can pay off its bondholders.

If considering only EBITDA, Microsoft's earnings steadily grow roughly 20% yearly. Hence, the company is going to look more attractive to lenders than Apple, whose EBITDA has been more volatile in the last five years, as shown in the following tables:

Debt-to-Equity

This ratio divides a company's total liabilities by its total shareholder equity. Ratios such as this are called "gearing ratios" because they help investors determine how much a company is leveraged.

This specific ratio is important because it indicates how much a company uses liabilities to finance its activities over wholly-owned funds. Therefore, it measures the ability of the shareholders' equity to cover all leftover liabilities in the event of a business turndown.

Hence, the firms that have more liabilities than equity are considered riskier to investors. It is expressed in the currency of the data and can be found in the company's balance sheet. The formula is best used when comparing multiple firms and is calculated as follows:

Debt-To-Equity = Total Liabilities/ Total Equities

An example of this ratio is Microsoft's total liabilities in 2021, 191,791 USD, and its total shareholder equity, 141,988 USD. Hence, the Debt-To-Equity ratio for Microsoft is calculated as follows:

Debt-To-Equity = 191,791/ 141,988

= 1.35 of debt for every 1 of equity

Apple's Debt-To-Equity ratio is calculated as follows:

Debt-To-Equity = 287,912/ 63,090

= 4.56 of debt for every 1 of equity

According to the Debt-To-Equity ratio, Microsoft is less leveraged and less risky than Apple. This is because, in the case of an economic downturn, its shareholders' equity nearly covers the outstanding liabilities.

This ratio divides a firm's total liabilities by its total assets and determines the extent of a company's leverage.

A ratio above 1 (100%) indicates that a large portion of a company's liabilities are funded by its assets, meaning it has more liabilities than assets. A high ratio indicates a higher risk of default if interest rates suddenly rise. The formula is as follows:

Debt Ratio = Total Liabilities/ Total Assets

An example of applying the formula would be that in 2021, Microsoft had 191,791 USD of total liabilities and total assets of 333,779 USD.

Debt Ratio = 191,791/ 333,779

Debt Ratio = 191,791/ 333,779 = 0.57 or 57%

Hence, Microsoft is not that risky because its liabilities are less than its assets. In Apple's case:

Debt Ratio = 287,912/ 351,002

Debt Ratio = 0.82 or 82.02%.

Therefore, according to this ratio, Apple is riskier than Microsoft because it has 25% (82% - 57%) more liabilities than Microsoft's assets. However, the result is still less than 1, which indicates that the company could still pay off its liabilities during an economic downturn.

Note that the acceptable ratio level varies from industry to industry. This is because it depends on the volatility of cash flows and the general liability ratios of the industry's firms.

For instance, if the industry has generally volatile cash flows and its firms have low liability ratios, then companies with high leverage would find it expensive to borrow and might be unable to repay their liabilities when cash flows are low.

Shareholder Equity Ratio

This ratio demonstrates how much of the company's assets have been generated by issuing shareholder equity instead of its liabilities.

The lower the ratio, the more the company has used liabilities to pay for its assets. It also shows how much shareholders might receive in a forced liquidation.

It is expressed as a percentage and can be found on a company's balance sheet. The formula is as follows:

Shareholder Equity Ratio = Total Shareholder's Equity/ Total Assets

In 2021, Microsoft's case:

Shareholder Equity Ratio =  141,988/ 333,779

= 0.42 or 42.53%.

Therefore, less than half of Microsoft's assets are financed by equity, which means that a large portion of its assets is financed by liabilities (58%).

If forced liquidation occurs, Microsoft's assets will be financed with 58% by liabilities, and the remaining 42% will be left to shareholders.

In the case of 2021, Apple:

Shareholder Equity Ratio =  63,090/ 351,002

= 0.179 or 17.9%

Hence, only 17.9% of Apple's assets are financed by equity, and liabilities finance the majority (83%).

This means that Apple's assets are financed with only 17.9% by equity, and the majority, 83%, is financed by liabilities. In a forced liquidation, this ratio does not directly indicate the portion available for shareholders.

Microsoft is favorable to creditors because its ratio is higher. This signifies the company's financial stability and ability to pay off its liabilities.

Interest Coverage Ratio

This ratio measures a company's ability to pay off the interest on its outstanding liabilities. It's measured by dividing a company's earnings before tax and interest by its interest expense for a given period.

The lower the ratio, the more the company is burdened by its interest expense and the less capital it has to utilize elsewhere.

Therefore, a higher ratio is favorable for creditors because it shows that a company can pay off its interest expense easily and has capital available for its bondholders. The formula is as follows:

Interest Coverage Ratio = EBIT/ Interest Expense

In Microsoft's case in 2021:

Interest Coverage Ratio = 69,916/ 2,346 = 29.80

This ratio is high and indicates the company can more than pay off its interest.

And in Apple's case, in 2021:

Interest Coverage Ratio = 108,949/ 2,645 = 41.19

Apple's ratio is higher than Microsoft's, indicating a stronger capacity to pay off its interest expense, and is considered favorable according to this ratio.

Assessing Debt Capacity Importance

Assessing Debt Capacity is important because it lets the company know what level of bond financing would be most beneficial. Likewise, it lets creditors know the risk of lending to a company. This is important because companies with higher leverage may be perceived as riskier.

Companies can assess the leverage of their competitors to evaluate their own as well. This is because companies' leverage level heavily depends on their industry's standards.

Creditors can assess multiple companies' debt capacities to evaluate which is the riskiest and the most profitable.

Likewise, firms can have unused debt capacity, representing the untapped portion of their borrowing ability available for future needs or financial transactions.

It is considered adequate leverage capacity when the ratio of credit to equity is greater than 1 (100%). Companies with adequate capacity will access more capital, possibly at a lower cost.

It is not the same as insufficient debt capacity. Insufficient capacity is when the company lacks sufficient cash flow to cover outstanding liabilities. Companies that face this issue will have difficulty gaining access to capital, and it will likely be more expensive than firms with sufficient capacity.

Throughout the years, changes in a company's leverage can be one factor signaling how well the company has been doing and how well it is predicted to do in the future.

Therefore, growth in company earnings signals the firm's growing ability to pay off its liabilities. This can lead the company to increase its leverage over time due to its increasing confidence in its ability to pay back creditors.

For instance, the debt capacity Excel model is used by investment bankers to determine how much leverage a company can handle in an M&A (Mergers and Acquisitions) transaction.

Researched and authored by Anja Corbolokovic | LinkedIn 

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Cost of Debt
• Debt Equity Ratio
• Debt Service Coverage Ratio
• Earnings Before Interest and Taxes (EBIT)
• Leverage