What is Debt Capacity? How does a firm decide its Debt Capacity?

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Businesses often need to source funds through debt and equity. Since equity cost is more than debt costs, organizations tend to choose debt over equity in their capital structure. Debt comes with a cost though because the companies need to pay interest to the lenders when they acquire debt. The interest they need to pay back is the minimum return they should earn to remain solvent in the long run.

What is Debt Capacity?

In general, a company should have all the funds required to pay back the minimum required amount of debt or contractual obligations. The amount of debt that can be repaid by the companies is known as its debt capacity.

  • Debt capacity should always be more than the requirements for funding the business and venturing into a profitable option by the business.

  • A firm can stay away from financial distress if it can have a good debt capacity to meet contractual obligations.

  • Investors and lenders usually look for companies that have high debt capacity.

  • Debt capacity should be taken as a measure of the capability to pay back the debt rather than a debt ratio. That is, debt capacity symbolizes the ability of a firm to meet its debt obligations in time.

High and Low Debt Capacity

High debt capacity is not always bad. If a firm can utilize more debt and can have a higher debt capacity, then it will increase shareholders' value. On the other hand, a firm with even low debt capacity can have problems if its liquidity is low. Therefore, calculating the effective rate of debt servicing is an important factor in calculating debt capacity.

Some companies state their target capital structure or debt financing in terms of ratings they desire. They choose a debt-equity ratio that is consistent with their rating. By working out the financials this way, the companies adjust their operations and other sources of finance, ensuring the feasibility of the given capital structure.

Debt capacity is therefore an important measure of valuation of a capital structure model. The businesses can gain enough insight of the problem at hand by utilizing the debt capacity measures for valuing a firm.

Demerits of Debt Capacity

Following are some of the demerits of using debt capacity as a tool −

  • Although debt capacity is a handy technique, the results obtained in the process are always not free from errors because identifying actual debt capacity is a cumbersome and erroneous process.

  • Rating a tool according to one’s own conditions is not a good measure. Companies tend to use their self-defined ratings to remain competitive in the industry and yet be weak at the core.

  • While it is good to have a good debt capacity, it is a tiresome process to find a holistic measure of a debt capacity rating that is accepted by all.

Updated on 24-Dec-2021 10:48:41