Borrower's Capacity: Assessing Debt Repayment Ability

What is Borrower’s Capacity?

Borrower's capacity refers to a company's ability to fulfill its debt payment obligations in terms of both timing and full amount. This concept is part of the five C factors in credit analysis, alongside collateral, covenants, character, and conditions.

The Internal Factors Influencing Borrower's Capacity

Internal factors are those that hinge on the specific characteristics of a company such as its ability to generate free cash flow FCF, balance sheet structure including assets and liabilities, or the current amount and maturity schedule of existing debt.

Analyzing external factors comprises industry dynamics like competition intensity and barriers to market entry, alongside broader economic conditions encompassing business cycle phases and interest rate levels.

Internal Factor Analysis

The analysis of internal factors involves scrutinizing several indicators within a company's financials and ratios, competitive standing, capital structure, strategic approach, and operational execution.

For instance, evaluating a company's competitive position includes assessing aspects such as market share size, brand influence over consumers, pricing power vis-a-vis suppliers and clients, differentiation in product offerings relative to competitors.

Financial Ratios Assessment

The evaluation of financials and ratios generally includes:

1 Profitability Metrics and Cash Flow Ratios:

Focus on metrics such as profitability margins, return on invested capital, and FCF margins. A company's capacity to settle its debt obligations deps heavily on its ability to produce enough cash flow. Analyzing these ratios ds in understanding if the firm is likely to generate sufficient resources for debt repayment.

2 Leverage Ratios:

The higher a company’s leverage, the greater challenge it faces in timely and full payment of debts. The analysis typically includes indicators like debt-to-capital ratio, debt-to-equity ratio, FCF-to-debt, net debt-to-EBITDA ratios, among others.

3 Coverage Ratios:

Understanding principal repayment needs beyond interest is crucial as not only the amount but also the interest rate significantly impacts a borrower's capacity. Hence, assessing coverage ratios such as EBITDA-to-interest expense and EBIT-to-interest expense ratios plays an important role.

Assessing Competitive Position

The analysis of a company’s competitive position requires consideration of factors like brand strength, market share size, differentiation in product offerings compared to competitors, pricing power over suppliers and clients. A strong competitive standing typically correlates with higher profitability margins and FCF generation, enabling the firm to benefit from better working capital management.

Strategic Planning and Execution Evaluation

It is essential to evaluate a company's strategic plan and execution track record comprehensively:

• Whether pursuing short-term goals that could hurt long-term value creation or incentivizing executives for value maximization.

• The riskiness of the strategy, particularly in cases of aggressive debt-financed acquisitions with limited strategic value.

• Appropriateness of capital sources used versus the company's goals, and potential overreliance on debt financing compared to equity investment.

• Consistency between the strategy adopted and the firm's strengths, or whether struggling agnst weaker competitors.

External Factors Influencing Borrower’s Capacity

External factors such as macroeconomic conditions including GDP growth rates, interest rate levels, and currency volatility can significantly impact a borrower's ability to meet debt obligations. Additionally, industry growth prospects-whether robust, stagnant, or declining-play an important role in assessing the risk associated with loan performance.

Further Learning Resources

CFI offers the Commercial Banking Credit Analyst CBCA certification program for those ming to advance their careers. Explore additional relevant resources below:

• Credit Score Analysis

• Debt Capacity Assessment

• Loan Structure Evaluation

• Evaluating Quality of Collateral

See all commercial ling resources
This article is reproduced from: https://corporatefinanceinstitute.com/resources/commercial-lending/borrowers-capacity/

Please indicate when reprinting from: https://www.669t.com/loan_limit/Borrowers_Capacity_Analysis_and_External_Factors.html