How much debt can a borrower afford?

Of the C's of Credit (capacity, capital, conditions, collateral, and character), this article focuses on capacity the borrower's ability to repay the loan. The authors present an analytical framework based on cash flows for evaluating financing alternatives and assessing how much debt a borrower can handle. They then discuss the effects of operating and financial leverage on a company's profits, cash flows, and loan repayment ability, and the importance of sensitivity analysis in dealing with risk.

There are two basic reasons why a company borrows money: 1) its internal and other sources of financing are exhausted; and 2) it seeks financial leverage--the magnifying effect on the returns to the company's owners as measured by earnings per share and return on equity. (1) Regardless, the question is, how much debt can a borrower afford? The answer: It depends.

Debt capacity should not be determined solely by industry averages or the available collateral. Capacity ultimately depends upon the borrower's repayment ability, which, in turn, depends on its ability to cover interest and principal payments out of cash flows.

Methodology: An Example

A methodology for evaluating a firm's debt capacity can be illustrated with a relatively straight-forward example. Assume that Shenandoah Company, Inc. (SCI) is a manufacturing company that has been quite successful. During the past five years, its sales grew at an annual compound growth rate of 8.1%, and its net profit margin increased from 2.4% to 3.5%. As a consequence of its success, the company is currently operating at near full capacity. At a recent meeting, SCI's board of directors approved a major plant expansion program.

The plant expansion program, which will take place during 2004, will result in a total financing requirement of $10 million by the end of the year. Once the new plant is operational, SCI expects its variable operating expenses to decline from 65% to 60% of sales, thanks to increased manufacturing efficiencies--primarily through reductions in per unit labor costs. The company's other operating expenses, which include fixed operating expenses that do not vary directly with sales, are expected to total $41 million in 2005, increasing $2.5 million in each year thereafter. (2)

SCI has been conservatively managed since its inception. Although the company occasionally uses its line of credit to finance seasonal fluctuations in receivables and inventories, SCI's board has historically avoided the use of long-term debt. In light of a recent disappointing performance of SCI's stock, however, the board is considering a five-year term loan for the expansion. The loan will have an interest rate of 8% and an annual principal repayment of $2 million. For the sake of simplicity, let's assume that the interest rate is fixed, as a more realistic floating rate loan introduces yet another element of uncertainty.

As shown in Figure 1, sales in 2004 are forecast at $110 million. Once the plant expansion is completed in 2004, management expects sales to grow 12% in 2005, 10% in 2006, 8% in 2007, and 6% in each year thereafter. The company's income tax rate is expected to be 35%, and net working capital is expected to average 18% of sales. In addition to the $10 million plant expansion in 2004, the company expects to spend $750,000 each year during 2005-09 on fixed-asset replacement and modernization. Depreciation expense, which is included in other operating expenses, is expected to be $1.5 million in 2005, increasing $50,000 in each year thereafter. Lastly, the company expects to pay $700,000 in common dividends in 2005, with an increase of $50,000 in each year thereafter.

Cash Flow Analysis

A borrower's debt capacity and loan repayment ability depend on cash flows in both good and bad times. Failure to make loan payments constitutes default and can lead to bankruptcy and liquidation. The more volatile and uncertain a company's cash flows, the more uncertainty there is regarding its ability to meet interest and principal repayment obligations and the less debt the company can handle. Conversely, the more stable and certain a company's cash flows, the more debt it can handle.

The term loan we're considering has an interest rate of 8% and requires annual principal repayment of $2 million. As is true with other borrowers, SCI's source of repayment is not profits; rather, it's from cash remaining after meeting the company's asset investment requirements--including net working capital and fixed assets needed to support sales growth--and dividends. The ability to cover financial obligations out of these cash flows in both good and bad times determines borrowing capacity. Numerous profitable companies do not produce positive cash flows. This is especially true for rapidly growing companies. For these companies, the additional net working capital and other assets needed to support sales growth often exceed profits, resulting in a growing need for cash until sales growth slows down or levels out. (3)

Figure 2 shows an analysis of SCI's cash flows. After adding back depreciation (a noncash expense) to net profit and deducting additions to net working capital and fixed assets, repayment of previously incurred debt (none, in this example), and dividends, SCI will have sufficient cash flows (labeled "cash flows available for debt repayment") to cover the annual principal payment of $2 million. Interest has already been deducted from EBIT in Figure 2. On a cumulative basis, the company's cash flows available for debt repayment over the five-year projected period total $27.8 million, well in excess of the $10 million loan. The company's "free cash flows" left over after deducting the $2 million annual principal payment are positive in each year, increasing from $536,000 in 2005 to $5.878 million in 2009.

Therefore, if SCI achieves the results based on the "most likely sales" assumptions, it should have no difficulty covering the interest and principal payments required by the term loan. However, the primary risk associated with debt pertains to the borrower's ability to cover interest and principal payments in bad times. For example, what if sales are lower than expected due to an economic downturn, changes in the company's competitive environment, or other adverse circumstances?

Figure 3 shows an analysis of SCI's cash flows assuming sales each year are 10% lower than expected. The reduction in forecasted sales dramatically reduces the company's forecasted EBIT and net profit. The relatively small 10% reduction in forecasted sales results in much larger percentage reductions in EBIT and net profit. In 2004, EBIT is 59.5% lower than originally projected and net profit is 65.9% lower because other operating expenses and interest expense are forecasted as dollar amounts and are unaffected by the 10% reduction in forecasted sales. Even though the dollar amounts of other operating expenses are forecasted to increase $2.5 million each year (all costs vary in the long run, if for no other reason than inflation), they do not vary directly with sales and hence are unaffected by the reduction in forecasted sales.

A given percentage change in sales results in the same percentage change in EBIT and net profit only if all of a company's expenses vary directly with sales, which is hardly realistic. Many expenses are fixed, at least in the short run. The higher the proportion of a company's expenses that are fixed, the greater the magnification effect. All else remaining constant, companies with cyclical sales and high fixed costs, such as highly automated, capital-intensive durable goods manufacturers, can afford less debt.

Operating and Financial Leverage

Our SCI example illustrates two types (stages) of leverage: operating leverage and financial leverage. Operating (first stage) leverage is the magnifying effect of a percentage change in sales on the percentage change in EBIT due to fixed operating expenses. In 2004, the percentage change in EBIT of 59.5% is almost six times the percentage change in sales. Financial (second stage) leverage, which begins where operating leverage leaves off, is the magnifying effect of a percentage change in EBIT on the percentage changes in net profit (and earnings per share) owing to fixed financial costs (interest) resulting from the use of debt financing. In 2004, the percentage change in net profit of 65.9% is 1.11 times the percentage change in EBIT. (4)

Even though the additions to net working capital are smaller at the lower sales levels (especially in 2005, when sales and net working capital are now forecasted to increase only $880,000 and $158,000, respectively), the dramatic reductions in forecasted EBIT and net profit result in significant reductions in SCI's cash flow available for debt repayment. As shown in Figure 3 and compared graphically with the most likely sales scenario in Figure 4, SCI's cash flows available for debt repayment are $1.55 million and $1.075 million in 2005 and 2006, respectively--well below the required annual $2 million payments. On a cumulative basis, the company's cash flows available for debt repayment over the five-year projected period total $11.923 million, only $1.923 million more than the $10 million loan. Although the company would be able to meet its interest and principal obligations over the five-year period, little cushion is left for even lower sales or other adverse changes, and, as previously noted, the company will encounter difficulties covering its principal payments from cash flows during 2005 and 2006. If there is a significant chance that sales could be as much as 10% lower than forecasted, the term and repayment schedule of the loan should be reconsidered.

[FIGURE 4 OMITTED]

Other Uncertainties

The level of sales is only one of the uncertainties facing SCI. For example, how certain are the forecasted variable operating expenses? SCI's forecasts are based on the expectation that the company's variable operating expenses are expected to decline from 65% to 60% of sales. What if the expected improved manufacturing efficiencies are not achieved? Is this expectation based on accurate estimates or wishful thinking?

Assuming the most likely sales forecast, Figure 5 graphically compares SCI's cash flows available for debt repayment if variable operating expenses are 60%, versus 65%, of sales. Figure 6 shows the same comparison assuming sales are 10% lower than originally forecast (pessimistic sales scenario).

[FIGURES 5-6 OMITTED]

Even if SCI achieves its most likely sales forecast, its cash flow available for debt repayment (Figure 5) will be insufficient to cover the annual $2 million principal repayment in 2005, 2006, and 2007 if its variable operating expenses remain at 65% of sales. Moreover, its cash flow available for debt repayment in 2005 and 2006 will be negative.

If SCI's sales are 10% lower than expected (pessimistic sales scenario) and its variable operating expenses remain at 65% of sales, its cash flow available for debt repayment will be negative in all five projected years.

This example underscores the need to perform sensitivity analysis of the input assumptions when evaluating a borrower's debt capacity and repayment ability. Often small changes in input assumptions dramatically affect the results, as is the case with both SCI's forecasted sales and variable operating expenses.

There are other uncertainties that should be explored. Is it reasonable to assume that net working capital will be 18% of sales--even during a recession? Manufacturers often end up with excess inventory and slower receivables collections during recessions.

Another uncertainty is the interest rate on the term loan. We assumed a fixed rate of 8% on the term loan, but in a more typical situation, the term loan would carry a floating interest rate. Even if the company achieves most of its forecast assumptions, a significant increase in interest rates could adversely affect its ability to cover its financial obligations.

Other uncertainties include the amount of other operating expenses, additions to fixed assets, and possibly even the company's income tax rate in future years. All of these uncertainties should be explored to properly assess the risk facing SCI and its lender. Thankfully, what-if analyses can be quickly and easily performed with computerized spreadsheets.

In the SCI example, we calculated cash flows available for debt repayment after deducting dividends. Although SCI management may believe strongly that dividends should be treated as a fixed obligation when assessing the company's cash flows and debt capacity, dividends on common stock as well as preferred stock are in reality discretionary. Failure to pay dividends will not lead to bankruptcy and liquidation. Hence, SCI's lenders may assess its cash flows available for debt repayment differently from the way in which management assesses it.

The Decision

So, how much debt can SCI afford? It depends. It certainly depends upon SCI achieving its sale forecast. There is little room for error. Given the company's operating leverage, even if sales are only 10% lower than forecasted, the company will have problems covering its financial obligations in 2005 and 2006. What is the likelihood that sales will be as much as 10% lower than forecasted? As previously mentioned, if there is a significant chance that sales could be as much as 10% lower than forecasted, adjustments to the term and repayment schedule of the loan should be considered.

SCI's debt capacity also depends on the degree to which the expected manufacturing efficiencies are achieved. If there is a significant chance that variable operating expenses will not decline to 60% of sales, equity or a combination of debt and equity may be better financing alternatives, especially if sales are also lower than forecasted. Equity also may be a better alternative in situations in which management would like to maintain a borrowing reserve (unused debt capacity), so that funds can be raised quickly to finance unforeseen needs and opportunities. Of course, additional external equity is not a viable financing alternative for many small and midsize companies. In such cases, lending decisions can be challenging, to say the least.

Ultimately, the amount of debt that SCI can afford depends on attitudes toward risk by its management, owners, and lenders. Some degree of risk is inherent in every commercial loan. However, an acceptable degree of risk to one borrower may be unacceptable to another. Some borrowers may be quite conservative, wishing to minimize the use of debt. Other borrowers may be highly aggressive regarding the use of debt. Conversely, an acceptable degree of risk to one lender may be unacceptable to another. Some lenders are more cautious than others. And, in an all-too-familiar situation, an acceptable degree of risk to a borrower may be unacceptable to its lender.

No mention has been made of the debt-to-equity ratios of SCI and other companies in the same line of business. Debt-to-equity ratios should be viewed with caution. Two companies in the same industry can have identical debt-to-equity ratios but significantly different cash flow generating and loan repayment capabilities because of differences in growth rates, cost structure, profitability, and asset turnover.

Conclusion

A proper assessment of a borrower's debt capacity and loan repayment ability requires forecasts of the company's profits and cash flows in both good and bad times. The methodology described and illustrated in this article provides a framework for evaluating such forecasts and assessing the risks associated with borrowing. Understanding the various sources of risk can lead to more appropriate loan structuring, support, and pricing.

Figure 1

Forecast Assumptions-2005-09

Sales growth                   Increase 12% in 2005, 10% in 2006, 8% in
                               2007 and 6% in each year thereafter
                               (Sales in 2004 = $110 million)

Variable operating expenses    60% of sales

Other operating expenses       $41 million in 2005; increases of $2.5
                               million in each year thereafter
Income tax rate                35%
Depreciation expense           $1.5 million per year; increases of
                               $50,000 each year thereafter (included
                               in other operating expenses)
Net working capital            18% of sales
Additional fixed asset         $750,000 each year
expenditures
Previously scheduled           $0
debt repayment
Dividends                      $700,000 in 2005; increases of $50,000
                               in each year thereafter

Figure 2

Risk Analysis

Cash Flows Available for Debt Service:
Most Likely Sales Scenario (000's)

                                               2005        2006

Sales                                        $123,200    $135,520
Variable operating expenses @60%               73,920      81,312
Other operating expenses                       41,000      43,500
  Earnings before interest & taxes (EBIT)       8,280      10,708
Interest expense                                  800         640
  Profit before taxes                           7,480      10,068
Income taxes @35%                               2,618       3,524
  Net profit                                    4,862       6,544
Add: Depreciation expense *                     1,500       1,550
Less: Additions to net working capital **       2,376       2,218
Less: Additions to fixed assets                   750         750
Less: Previously scheduled debt repayment           0           0
Less: Dividends                                   700         750
  Cash flows available for debt repayment       2,536       4,377
Less: Principal repayment (new loan)            2,000       2,000
  Free cash flows                                $536      $2,377

                                               2007        2008

Sales                                        $146,362    $155,143
Variable operating expenses @60%               87,817      93,086
Other operating expenses                       46,000      48,500
  Earnings before interest & taxes (EBIT)      12,545      13,557
Interest expense                                  480         320
  Profit before taxes                          12,065      13,237
Income taxes @35%                               4,223       4,663
  Net profit                                    7,842       8,604
Add: Depreciation expense *                     1,600       1,650
Less: Additions to net working capital **       1,951       1,581
Less: Additions to fixed assets                   750         750
Less: Previously scheduled debt repayment           0           0
Less: Dividends                                   800         850
  Cash flows available for debt repayment       5,941       7,074
Less: Principal repayment (new loan)            2,000       2,000
  Free cash flows                              $3,941      $5,074

                                               2009

Sales                                        $164,452
Variable operating expenses @60%               98,671
Other operating expenses                       51,000
  Earnings before interest & taxes (EBIT)      14,781
Interest expense                                  160
  Profit before taxes                          14,621
Income taxes @35%                               5,117
  Net profit                                    9,503
Add: Depreciation expense *                     1,700
Less: Additions to net working capital **       1,676
Less: Additions to fixed assets                   750
Less: Previously scheduled debt repayment           0
Less: Dividends                                   900
  Cash flows available for debt repayment       7,878
Less: Principal repayment (new loan)            2,000
  Free cash flows                              $5,878

* Included in other operating expenses

** 18% of change in sales (sales in 2004 = $110 million)

Figure 3

Risk Analysis

Cash Flows Available for Debt Service:
Pessimistic Sales Scenario (10% Lower Sales) (000's)

                                               2005        2006

Sales                                        $110,880    $121,968
Variable operating expenses @60%               66,528      73,181
Other operating expenses                       41,000      43,500
  Earnings before interest & taxes (EBIT)       3,352       5,287
Interest expense                                  800         640
  Profit before taxes                           2,552       4,647
Income taxes @35%                                 893       1,627
  Net profit                                    1,659       3,021
Add: Depreciation expense *                     1,500       1,550
Less: Additions to net working capital **         158       1,996
Less: Additions to fixed assets                   750         750
Less: Previously scheduled debt repayment           0           0
Less: Dividends                                   500         550
  Cash flows available for debt repayment       1,550       1,075
Less: Principal repayment (new loan)            2,000       2,000
  Free cash flows                               $-450       $-925

                                               2007        2008

Sales                                        $131,725    $139,629
Variable operating expenses @60%               79,035      83,777
Other operating expenses                       46,000      48,500
  Earnings before interest & taxes (EBIT)       6,690       7,352
Interest expense                                  480         320
  Profit before taxes                           6,210       7,032
Income taxes @35%                               2,174       2,461
  Net profit                                    4,037       4,571
Add: Depreciation expense *                     1,600       1,650
Less: Additions to net working capital **       1,756       1,423
Less: Additions to fixed assets                   750         750
Less: Previously scheduled debt repayment           0           0
Less: Dividends                                   600         650
  Cash flows available for debt repayment       2,330       3,198
Less: Principal repayment (new loan)            2,000       2,000
  Free cash flows                                $330      $1,198

                                               2009

Sales                                        $148,007
Variable operating expenses @60%               88,804
Other operating expenses                       51,000
  Earnings before interest & taxes (EBIT)       8,203
Interest expense                                  160
  Profit before taxes                           8,043
Income taxes @35%                               2,815
  Net profit                                    5,228
Add: Depreciation expense *                     1,700
Less: Additions to net working capital **       1,508
Less: Additions to fixed assets                   750
Less: Previously scheduled debt repayment           0
Less: Dividends                                   700
  Cash flows available for debt repayment       3,770
Less: Principal repayment (new loan)            2,000
  Free cash flows                              $1,770

* Included in other operating expenses

** 18% of change in sales (sales in 2004 = $110 million)

Notes

(1) The financial leverage resulting from debt can be quite appealing and a strong motivating factor for some borrowers. Indeed, the higher return that can result from debt financing has motivated numerous leveraged buyouts over the past couple of decades. For other borrowers, the higher returns resulting from financial leverage are not the primary motivating factor for obtaining debt financing. They simply need funds.

(2) It is important to distinguish between variable and fixed expenses when assessing a company's debt capacity. Company financial statements typically do not explicitly break down expenses into fixed and variable categories, so this classification of expenses requires judgment. Variable costs are expected to vary directly with changes in sales volume and include such items as direct labor and materials, supplies, packaging, freight, and sales commissions. Fixed costs--such as indirect labor and overhead, officers' salaries, rent, depreciation, property taxes, insurance, maintenance, and salespersons' salaries--remain relatively fixed as sales volume changes, at least in the short run. Some expenses are neither exclusively fixed nor variable, but contain both fixed and variable components. An example would be selling expenses, if both salaries and commissions are included. Often borrowers can provide additional insight and more detailed breakdowns of expense items to facilitate classification as fixed or variable.

(3) Discussions of the effects of sales growth on profits and cash flows and the maximum rate of growth in sales that can be achieved, given a company's profitability, assets utilization, dividend payout, and financial leverage, can be found in George W. Kester, "Why Borrowers Become Profit Rich and Cash Poor," The Journal of Commercial Lending, October 1992, pp. 45-53, and George W. Kester, "How Much Growth Can Borrowers Sustain?" The RMA Journal, July-August 2002, pp. 49-53.

(4) For operating leverage to be beneficial, the company must be operating above its breakeven point. For financial leverage to be beneficial, the interest rate on its debt must be less than the return on assets as measured by EBIT/total assets.

Contact George by e-mail at kesterg@wlu.edu.

Kester is the Martel Professor of Finance and head of the Department of Management, Washington and Lee University, Lexington, Virginia, and formerly held various positions in commercial lending with First Union National Bank. He is a lead faculty member of the Central Atlantic School of Commercial Lending. Hoover is assistant professor of finance and Pirkle is professor of management at Washington and Lee University.

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