Debt capacity may sound like a confusing financial term, but it refers simply to the amount an individual or organization can borrow. Specifically, it refers to the amount of funding an organization can borrow before becoming financially constrained. This point varies by industry and business. The journal article "Determinants of corporate borrowing" is usually a required read for any first year MBA student in finance. Among other things, the study uses debt-to-equity and interest coverage ratios to determine debt capacity.
Step 1
Review the debt coverage ratio (DCR). The DCR is often used by lenders as a measure of debt capacity. The equation uses earnings before interest, taxes and depreciation or amortization (EBITDA) or cashflow to pay debt as the numerator and the corresponding debt payments due in that same period as the denominator.
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Step 2
Calculate the interest coverage ratio. The interest coverage ratio is used in conjunction with the DCR to determine debt capacity levels. Again, EBITDA is used as the numerator and interest payments are used as the denominator. The lower the ratio--that is, the fewer times the company can pay its interest payments with available profits--the more the company is burdened by debt expense.
Step 3
Compare against other companies in the same industry. A ratio is nothing without comparable numbers. Use an online financial research tool like Yahoo! Finance to look up DCR and interest coverage ratios. A company with low DCR and interest coverage ratios has a lower capacity for debt than companies with higher ratios.
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