Debt Capacity Analysis
Debt capacity represents the present value of sustainable cash flows available to service and repay senior debt over a 7–10 year horizon. It’s a foundational concept in capital structuring, credit analysis, and M&A financing decisions — helping determine how much leverage a company can responsibly carry.
🧮 How Do We Define Cash Flow?
There are two commonly accepted ways to define cash flow when calculating debt capacity:
- EBIDA – Replacement CAPEX
Cash before interest, depreciation & amortization, minus ongoing maintenance capex. - Tax-adjusted EBIT + Depreciation & Amortization – Replacement CAPEX
Accounts for taxes while retaining the non-cash benefit of depreciation.
💡 Only recurring and operationally available cash flows should be included — growth investments and non-operating inflows are excluded.
🔧 Replacement Capital Expenditure
Replacement CAPEX refers to the reinvestment needed to sustain operations at current output. A reliable proxy is:
📉 Annual Depreciation – representing the wear and tear of assets that must be replaced regularly.
⚠️ Growth capex should not be included when evaluating debt sustainability.
📉 What Discount Rate Should Be Used?
| 📌 Cash Flow Definition | 💰 Discount Rate |
|---|---|
| EBIDA – Replacement CAPEX | Fixed-rate borrowing cost (7–10 year term) |
| Tax-adjusted EBIT + D&A – Replacement CAPEX | Tax-adjusted cost of debt: i × (1 – tax rate) |
🎯 This aligns the discount rate with the cost of debt the company would realistically incur.
🚫 Why Zero Terminal Value?
Most credit models assume a terminal value of zero — meaning lenders prefer to see full repayment during the loan term, not after:
⏱️ Cash flows forecasted over 7–10 years
🔁 No reliance on future refinancing or residual asset value
📈 Practical Use Cases
Debt capacity analysis is not just theoretical — it’s applied in two common
ways:
Bottom-Up Approach: Use actual or projected cash flows to
determine how much debt a company can raise today.
Reverse Stress Testing: Calculate the minimum cash flows
needed to support current and future debt balances.
✅ These tools are essential in LBO models, capital budgeting, and financing
strategy reviews.
📎 Download the Visual Guide –> : Debt Capacity Analysis
🔗 Related Modules
Adjusted Working Capital (AWC) AnalysisEnterprise Value (EV) AnalysisDuPont Analysis
🏷️ Tags:
#DebtCapacity #CreditAnalysis #CashFlowModeling #M&A #CapitalStructure #LeverageAssessment #FinancialModeling
