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How to Calculate Debt Capacity of Company

Debt capacity means capacity of company to repay the Debt. To calculate the debt capacity of company is effected by lots of factors. But on the basis of risk and return in company, we can calculate or measure the debt capacity.

There are two main point which is seen by any financial institute when it decides to give debt to any company.

1. If there is low return. Company's capacity to earn money is low. Low return is also getting through high fluctuation rate. Risk of getting such return is high. At that time, financial institute will give less debt to such company because debt capacity of company is low.

2. If there is high return. Company's capacity to earn money is high. There is low rate of fluctuation in his past return. Risk of getting such return is low. At that time, financial institute will give huge debt to such company.

Both above are the basic points. Now, it is the duty of finance manager to go deep for estimating the risk and return of company.

Following are the main methods which will be helpful for calculating the debt capacity of company.

1. Debt to Total Capitalization Ratio

It will tell us, how much company has already taken the loan of total capitalization. In total capitalization,we will include capital, reserve and debt. For example, if equity share capital is $ 10,00,000. Total reserves are $ 2,00,000 and total debt is $ 4,00,000. It means Debt to total capitalization ratio is 25%. We have to pay $ 25 out of $100 outside  and $ 75 is our own. So, it will be helpful to decide the capacity of debt of company. Instead of debt to total capitalization ratio, we can calculate debt to total asset ratio, just see following screenshot. It will give more clear idea about the current debt capacity of company.




2. Gear Ratio 

Gearing ratio is the relationship between equity share capital and preference share capital + debt.

Gearing Ratio = Equity share capital / preference share capital + debt

This ratio is also helpful for calculating the debt capacity of company. Only that company whose ratio will more than 50% will be good. If this ratio is 25% or less, it is sign of risk. Because both pref. share capital and debt have no right to vote and both are not owners of company. So, company has to reduce both as soon as it gets the profit.

3. Debt Equity Ratio 

We can also find debt equity ratio. It is also helpful for finding company's solvency. You can know about this at here.

4. Cash Payment Capacity

For knowing debt capacity, we should know the cash payment capacity. If its profit and loss account is showing that there are lots of expenses which still payable. It means, it is earning profit but cash payment capacity is very low. Now, you can easily know when a company can not pay the small expense, then how can it pay the big debt?

5. Working Capital Capacity 

We should also find the working capital. Its value will be helpful for finding the capacity of working capital. There is a statement and its name is Changes in working capital. Both should be calculated for knowing debt capacity. If working capital is low. Working capital's current requirement is very high, then it is the sign, company's debt capacity is low.

Related : Ratio Analysis 

Categories : Finance  | Step by Step Accounting Guide

COMMENTS

: 2
  1. estimation of debt capacity and its impact on return on equity for select debt free companies.can anyone help me out with this project.

    ReplyDelete
  2. Very informative and useful, you showed very useful info about financial ratios Formulas. Great and Detailed work.

    ReplyDelete
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Accounting Education: How to Calculate Debt Capacity of Company
How to Calculate Debt Capacity of Company
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