Why It's Important to Know Your Business's Debt Capacity

With everything business owners have on their plate, it’s often difficult to know at any particular time whether they have the capacity to expand should the opportunity arise. To know for certain requires having a firm grasp of the business’s financials, and many times it’s not until loan applications are submitted to multiple lenders before the answer is clear. All the time and effort spent to get an answer can cost the business opportunities.

Business owners can stay out of the dark on this issue by having constant access to the business’s debt capacity, which is a measure of the business’s capacity to take on more debt.

What Exactly is Debt Capacity?

Essentially, debt capacity is a measure of the amount of debt your business can handle at any one time while maintaining the ability to repay it under the terms of the loan. It’s an essential measure because lenders look at it in determining whether a business can generate enough cash flow to repay the loan on time.

An analysis of debt capacity begins with a business’s cash flow statements and balance sheet. A key metric in the analysis is the business’s EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization). Businesses with strong EBITDA are considered better risks for their capacity to generate sufficient earnings that can be allocated to loan repayment. Lenders look at the debt to EBITDA ratio to assess debt capacity. The debt to equity ratio, found in the balance sheet, is also an important metric.

How Knowing Debt Capacity Helps Your Financial Management

Having a constant awareness of your debt capacity, which can change periodically, can help your business in the following ways:

More Meaningful Strategic Planning

It’s not uncommon for a management team to spend time and resources developing a strategic plan only to find out they can’t obtain the funding to implement it. With an awareness of your business’s debt capacity, strategic planning becomes more meaningful and efficient.

Be Ready for Opportunities

You never know when an opportunity will arise and when it does, whether you will have the capacity to fund it. If you are unaware of your debt capacity, the opportunity may pass you if you can’t get a quick answer from your lender.

Speed Up the Lending Process

When you need to take out a loan, it could require several meetings with your lender to answer questions. If you don’t have the information the lender needs, it raises more questions and another delay in determining how much you can borrow. Knowing your debt capacity will get you past many preliminary questions and to your loan amount more quickly.

If you want to ready for the next opportunity, it would be worthwhile to meet with your business bank specialist to learn how to calculate your debt capacity. That way, you can assess your capacity to borrow well in advance of your need.