Why Smart CFOs are Reassessing Debt Capacity

Debt capacity is a measure of the total amount of debt that lenders are 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. Additionally, with the new CARES Act and the SBA’s release of new loan programs, a company’s total debt capacity can change based on its eligibility for the new programs.

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.

SBA Loans: SBA Lenders will leverage government guarantees to provide loans to companies that run asset lite business, which would otherwise not be able to access the traditional commercial loans. Debt capacity is often set based on how much cash flow a company can use to pay principal and interest of the loan. Typically lenders look for at least 1.25x coverage. Companies must be eligible under the SBA regulations to qualify. 

Paycheck Protection Program (“PPP”) Loans: The SBA recently provided access to Paycheck Protection Program, which offers forgivable loans in an effort to help companies avoid layoffs related to the corona virus impact. The loan size is based on a 2.5x multiple of the average monthly payroll. These loans are designed for immediate support and companies will need to look to other lenders for longer term financing needs. Companies must be eligible under the SBA regulations to qualify. 

Venture Debt Loans: There is an ecosystem of lenders that provide financing for high growth venture capital or private equity backed companies. Lenders are often lending off multiples of recurring revenue or a percentage of the most recent equity round or simply based on the reputation of the institutional investors backing the borrower.