Debt capacity

Debt capacity
See also
Borrowing capacity Capital buffer Capital Base Funding Operations Defensive strategy Total capitalization Functions of financial management Eurocredit Capital rationing

Debt capacity it is the maximum amount that a bank can lend to a company for a loan, given its current situation and financial capacity. This is a way how banks protect against various economic factors. These may be mainly numerous bankruptcies of companies, transaction costs, changes in the market. The amount that a company can borrow also depends on the bank that has been chosen to lend.

Debt capacity is otherwise the permissible level of indebtedness or the maximum possibility for a company, state or household to incur debt. It talks about whether the company can take on debt and to what extent the company can be indebted.

The most important questions that a company has to ask itself is:

• Can a company get into debt?
• To what extent can a company be indebted?

This is a very important information when planning the future budget of the company and its structure. A failure to maintain an adequate level of indebtedness can lead to a liquidity ratio crisis for the company and no solvency in future operations.

The amount of debt that a company can take is always limited and depends primarily on its ability to repay the loan instalments and the total amount of credit taken out. The ability to repay the loan is ultimately assessed by buy-side investment bank. When granting credit to a company, they have to be careful and double-check everything, because they need to know how risky that decision is and what the other sources of funds and options are.

Appropriate financing arrangements (source of funds)

It is always a difficult choice to find a source of funds of company's activities. As regards external sources it is usually a choice between equity financing or external financing by incurring debt ( debt financing ) Both of these methods have their advantages and disadvantages, but an important principle to be observed during the company's capitalisation plan is to maintain a 1:1 ratio. Maintaining such a ratio with both methods of financing is associated with a much lower risk in the company's operations than maintaining other ratio.This ratio may be higher in companies where the risk ratio is negligible and the risk of fluctuations in earnings is low.

References

• Barclay J., Smith W., Morellec E., (2006), On the Debt Capacity of Growth Options , The University of Chicago Pressp, p.37-39
• Brigham F., Kumar A. & Sharma R., (1998), Financial management: theory and practice, Atlantic publishers and distributors, p.86-87
• Falato A., Kadyrzhanova D., Sim J., (2013), Rising Intangible Capital, Shrinking Debt Capacity, and the US Corporate Savings Glut p. 19-20
• Leary M., Roberts M, (2010), Journal of Financial Economics, Elsevier B.V., p.336-354
• Shleifer A, Vishny R., (1992), The Journal of Finance, “Liquidation Values and Debt Capacity: A Market Equilibrium Approach.”, National Bureau of Economic Research, Working Paper No. 3618, p. 1-11,20-35
• Talmor A. & Vasvari F., (2011), International private equity, John Wiley & Sons Ltd. Publication, ex.13.4 Determine Transaction Structure
• Turnbull S., (1979), The Journal of Finance, "Journal Article", Willey-Blackwell, Vol. 34, No. 4 pp. 931-940

Author: Maciej Plęskowski