My first job out of public accounting was for a real estate developer who developed rental properties. Once he had them fully rented out, he would hold them for the free cash flow and never sell. During that time, cap rates kept going down so I would urge him to sell properties that were fully occupied and realize huge gains. I was so naive. He taught me one of my first lessons in business:
Why would you sell and pay tax, when you can simply refinance the asset and use the cash elsewhere?
We often think of debt as a dirty word, but in fact, some debt can optimize a company's capital structure. Why would you want to increase your company's debt load? For companies with clean balance sheets that have stable cash flowing businesses, leveraging the assets can be a good way to unlock cash that can be paid to the shareholders through dividends. Of course, too much debt increases financial risk because it can leave the company unable to meet its debt obligations. So, how much is too much? That's an important question for companies who are thinking of increasing their debt load for monetization instead of just selling the business.
A company’s capital structure is unique and may change depending on changing business circumstances. However, if a company has the capacity to include debt in its capital structure, it should do so because debt reduces a company’s weighted average cost of capital (WACC). As you might imagine, how much debt a company's balance sheet can handle is somewhat subjective given that several factors need to be considered. These factors fall into three primary categories:
- The tangible asset backing the company to support its debt;
- The company’s ability to service its debt with cash flow; and
- Qualitative factors specific to each company.
#1 Tangible Asset BackingThe level and quality of tangible assets within a company are key attributes that drive how much debt should be in the capital structure. Here are some guidelines (they vary, but these are good starting points) that lenders use to assess a company’s asset backing capabilities:
- Accounts Receivable
Banks will typically lend up to 75 percent of a company's accounts receivable. Keep in mind that lenders will usually deduct any amounts over 90 days (unless they are from an investment-grade customer) from total accounts receivable. So, if a company has a 100-day receivable from a private numbered company, it is highly unlikely the company will be able to borrow against this receivable.
Banks will lend up to 50 percent of inventories. This can include raw materials, work in progress and finished goods. A physical count is typically not required by most senior lenders. However, the company principal will usually be asked to sign a statutory declaration validating the inventory amount.
- Real Estate
If your company owns real estate, you can leverage it to 75 percent of its fair market value. An appraisal is needed to validate the fair market value.
- Capital Assets
You can usually get 70 to 85 percent of the fair market value of capital assets. Again, an appraisal may be needed to validate the fair market value. Also keep in mind that an appraisal happens at a point in time and lenders may want the company to conduct a regular (most likely annual) appraisal of capital assets. This is a costly exercise, and companies should work with the bank to minimize this requirement - and perhaps even have it done once every three years unless conditions change.
- Tangible Net Worth
Although not a pure asset-backing metric, lenders expect a minimum net worth in a company to ensure it is not under-capitalized. The expected tangible net worth may be as low as 25 percent and as high as 75 percent, depending on the company’s risk profile and type of business.
- Current Ratio
Current ratio, like tangible net worth, is not a pure asset-backing calculation, but banks often use it anyway. It determines how much net working capital the company has and how the current assets can cover the current liabilities. Lenders usually expect a minimum of 1.25X coverage.
#2 Debt Servicing CapabilitiesWhether a company can afford its debts is a major factor in how much it can borrow. That's why lenders gauge a company’s ability to generate cash flow for servicing debt using an array of different ratios. The more common ones include:
- Funded Debt to EBITDA
This ratio measures the company's total debt against the recurring annual EBITDA it generates. EBITDA is used as a proxy for operating cash flow (OCF). The ratio is typically set anywhere between 2X and 4X, depending on the size and risk profile the lenders assign to the company.
- Fixed Charge Ratio
This ratio measures the company’s cash flow, including payments related to off balance sheet instruments, such as leases and capital commitments against the company's total debt obligations. Usually, this ratio is expected to be in the 1.3X to 1.8X range, depending on the company.
- Interest Coverage Ratio
This ratio is similar to the fixed charge ratio, but it only tests the company’s ability to cover its interest payments. It usually takes EBIT and divides it over annual interest, expecting a minimum coverage of 2X to 2.5X.
#3 Qualitative MeasuresThere are many other qualitative measures that determine how much debt a company's capital structure can absorb. Some of these measures include:
- How high the company’s fixed operating costs are (its operating leverage). The higher this leverage is, the more volatile cash flows will be if revenues fluctuate, putting the company at risk of being unable to service its debt.
- The stability or cyclicality of the industry in which the company operates. Stable industries typically allow for greater debt capacity.
- The type of growth plans the company has. For high-growth companies, a larger level of equity is required as lenders usually seek stable, cash flowing companies to finance.
- The strength and capability of the company's management team.
- The company's tax rate, which is based on where it's located. The higher the tax rate, the more advantageous it is to use debt, as the interest charged generates a larger tax deduction against income.