The debt capacity of a firm is its ability to take on additional debt and to service the existing debt. Debt capacity analysis helps organizations determine how much additional debt they can issue before it raises the concerns of lenders and credit rating agencies. The analysis results may be disclosed to stakeholders in terms of the debt service coverage ratio -- income before interest and tax expenses divided by interest expenses -- and for public sector organizations, the net debt per capita -- total debt minus cash assets divided by the population.
Government agencies such as municipalities cannot issue shares to fund major projects such as new highways. They often must issue debt to raise funds. Private sector companies have more flexibility, but debt financing especially in a low interest rate environment allows them to raise funds without giving up control. Excessive debt limits organizational flexibility in budgetary and investment decisions and may lead to credit rating downgrades, which usually makes borrowing more difficult and expensive.
Texas A&M University Professor John C. Groth, in his QFinance article on capital structure, uses the terms "good" and "bad" debt capacity to characterize corporate debt levels. A company with unused good debt capacity usually has a debt-to-equity ratio -- total debt divided by total equity -- of less than 1, which means easier access to funds. Bad debt capacity limits flexibility and, for public companies, adversely impacts the stock price. Debt capacity is tied to repayment capacity -- for a small business, such as a family farm, this means having sufficient cash flow to make the debt payments. Financial ratios are part of this analysis. For example, the current ratio -- current assets divided by current liabilities -- indicates how easily a business can pay its current bills: the higher the ratio, the better. The debt service coverage ratio, also known as the times-interest-earned ratio, reflects how easily the company can make its debt payments from its earnings. The higher this ratio, the better a firm's repayment capacity and debt capacity. Conservative and realistic cash flow projections help firms adopt proper strategic measures to improve their current and future debt capacities.
Organizations may employ several strategies to ensure an optimal debt capacity. For example, a company that pays regular dividends can reduce the dividend payments to increase retained earnings and reduce the debt-to-equity ratio. Companies may sell off some of their assets or issue shares to pay down their debt. In a period of falling interest rates, companies can buy back their older higher-interest paying debt and refinance at lower rates. Operational measures such as conservative cash flow budgeting, controlling expenses and limiting borrowing are other ways to reduce interest expenses and maintain optimal debt capacity.
Groth suggests that investors should watch out for company management who use debt to further their own interests instead of shareholder interests. For example, management may saddle a company with excessive debt to make the balance sheet unattractive for potential buyers. In the public sector, debt capacity analysis should be balanced with public policy objectives. For example, voter-mandated measures must be implemented regardless of the debt levels.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.