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Matthew Bjonerud
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.
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CFOs 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.
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I'm an expert in corporate finance and debt management with a proven track record in the field. My expertise stems from years of practical experience as well as a comprehensive understanding of financial principles. I've successfully navigated the complexities of debt capacity, helping businesses optimize their financial structures and make informed decisions regarding expansion, acquisitions, and strategic projects.
Now, let's delve into the concepts presented in the article:
1. Debt Capacity:
- Definition: Debt capacity is the total amount of debt that a lender is willing to provide to a business. It's a critical measure of a company's ability to borrow, influenced by various factors such as balance sheet items, cash flow strength, enterprise value, and top-line revenues.
- Variability: The debt capacity can vary based on the type of loan and lender. For instance, a company with weak cash flow but sufficient collateral may have a low debt capacity for cash flow-based loans but a high capacity for asset-based loans.
2. Cash Flow-Based Loans:
- Calculation: Lenders determine the loan amount by taking a multiple of the company’s EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) while considering the balance sheet strength.
- Features: These loans are often lower priced but come with more restrictive covenants.
3. Asset-Based Loans:
- Considerations: Lenders assess accounts receivables, inventory, and other asset classes to determine the advance rate. These loans typically have fewer covenants but may require regular examinations of assets.
4. Importance of Knowing Debt Capacity:
- Strategic Planning: Knowing debt capacity in advance facilitates efficient strategic planning, ensuring that proposed projects can be financed.
- Board Inquiries: Boards may inquire about the feasibility of funding initiatives. Lack of awareness of current market conditions or credit standing can lead to a distorted view of debt capacity.
- Negotiation Advantage: CFOs armed with comprehensive data on debt capacity have an advantage when negotiating with current lenders and exploring opportunities with non-traditional lenders.
5. Benefits of Market Intelligence:
- Informed Decision-Making: Understanding debt capacity based on a company's financial profile and deal structures aids in making informed decisions when selecting loan types and lenders.
- Time Efficiency: Market intelligence shortens the time required to secure financing by streamlining the decision-making process.
In conclusion, having a clear understanding of debt capacity is vital for financial management, enabling businesses to navigate strategic projects, address tough board questions, and negotiate favorable deals. It's a proactive approach that positions CFOs to make well-informed decisions in a dynamic financial landscape.
