Debt capacity overview. We look at debt capacity for several reasons. Similar to liquidity analysis, debt capacity allows us to see the what ifs of several types of scenarios so we can assess the risks and opportunities. One thing we need to know from debt capacity analysis is how much additional leverage can be supported by the business should the company need to consider a potential acquisition, or LBO/MBO, or leverage buyout or management buyout. Also, at times when share prices are low, management might consider large share buybacks which are not terribly productive from the credit perspective, but for a highly rated company, it would not be the worst reason to borrow money. Secondly, we would like to know how much room there is for a company to struggle. This can be both during cyclical or seasonal downturns, or for a company in a turnaround. Possibly it could be a situation like the mass economic shutdowns over the COVID-19 pandemic. When we talk about how much room or how much capacity, what is it that we want to know? One thing that is very important to creditors and borrowers is how much incremental leverage will result in a ratings downgrade or a sub-investment grade rating? Another version of that question is how much leverage is the bank or bank group comfortable with? The most extreme question would be, how much leverage would actually swallow the company? Debt capacity is a dance between three parties, the market, the borrower, and the lender. The market dictates if there is appetite for this kind of leverage and at what price. Some of that is based on the cash flowing into the market, and some is based on the success of the previous deals. At a certain point, the demand can dry up regardless of the return offered and there is no longer the ability to get a deal done. The lender is taking its pricing cues from the market and also gauging the demand to determine if the deal can be successfully syndicated or traded in the secondary markets. It is also examining the credit worthiness of the borrower using all the tools we've already discussed. The borrower is ultimately being judged on its cash flows, size, strength, and reliability compared against the existing and proposed leverage. While total debt to EBITDA is the most quoted ratio in the market, and often the most common covenant, most bank analysis will be done on more specific cash flow metrics, such as levered cash flow, which tells the bank exactly how much cash is available to repay debt after all necessary expenditures, including taxes and interest on current debt are made. The borrower is also a factor in debt capacity, in that it might not wanna jeopardize a certain credit rating or go below an investment grade rating in which case, the capacity of course is limited. It might also be limited by existing debt covenants. In an LBO, the existing debt is almost always refinanced so that is not so much an issue as the market's appetite for the debt.
