What Business Leaders Need to Know About Debt Capacity
Founder & CEO
With a tight schedule and multiple initiatives on your plate, having the financial guidance on hand to know whether expansion or acquisition is possible can be more difficult than you would think. Getting a definitive answer means gathering financials, current obligations, and completing applications to multiple lending institutions. The time and effort this requires can often kill a deal or opportunity.
Business leaders need to be constantly aware of how their company’s financial performance and market shifts affect its debt capacity, which is the best measure of your business’ ability to borrow.
What is debt capacity?
Debt capacity is a measure of the total amount of debt that a lender is willing to provide your business. Each lender has their own policy on how much debt they lend to borrowers. Factors that drive this can range from balance sheet items, cash flow strength, enterprise value, and even top line revenues. The debt capacity of a borrower will vary depending on what type of loan and lender they use. For example, a company with weak cash flow but sufficient collateral could result in a very low debt capacity for cash flow based loans, but a high debt capacity for asset based loans. It’s important that CFOs consider the various types of lenders and loan options out there and how those affect their debt capacity. The two most common ways lenders consider debt capacity is by evaluating the company’s cash flow and evaluating its assets.
Cash flow based: Lenders will calculate the amount they are willing to loan a company by taking a multiple of the company’s EBITDA with consideration given to its balance sheet strength. These loans are often lower priced, but have more restrictive covenants.
Asset based: Lenders will consider the company’s accounts receivables, inventory, and other asset classes to determine the advance rate given to each. These loans often have few covenants, but most likely require a regular field exam of your assets.
How knowing debt capacity helps financial management
The following situations demonstrate why being prepared to answer debt and borrowing questions can benefit your organization.
1. Strategic projects require funding
Knowing your debt capacity ahead of time, based on both your cash flow and assets, makes creating strategic plans more efficient. Strategic plans are often approved by the board without much attention to how they will be financed. However, if the financing can’t be sourced, then the plans cannot be fulfilled. Finance teams with well-researched financing strategies strengthen their plan, and increase their chances of success. On the contrary, providing a strategic plan or proposing an acquisition or expansion project that includes unrealistic financing requirements, will negatively impact the reputation of the finance team.
2. Boards tend to ask tough questions
You never know when the board will surface an initiative of their own and ask you if it’s possible to fund it. If you sourced financing over six months ago, then you may not be aware of how the market has changed or how your credit standing has affected your ability to borrow. This lack of awareness could lead to a warped view of your debt capacity. In order to get an objective view, you cannot simply ask one banker or one type of lender. Your banker may only be focused on cash flow lending, but the company may be better off using an asset based loan.
3. CFOs with the best data get the best deal
Knowing your debt capacity based on your company’s financial profile and various deal structures not only provides an advantage when negotiating with your current lender, but can also open up new opportunities with non-traditional lenders. Market intelligence allows you to make the most informed decision when choosing loan types and lenders, and helps shorten the time in which it takes to secure financing.