Repayment capacity measures comprise the capital debt repayment capacity, capital debt repayment margin, replacement margin, term debt, and capital lease coverage ratio. Capital debt repayment capacity, capital debt repayment margin, and the term debt and capital lease coverage ratio mark a borrowers’ capacity to repay operating loans. Also, to protect the current part of principal and interest due on noncurrent loans such as building, land loan, or machinery. To evaluate if a borrower has adequate funds to pay off term debt replacement margin and the replacement margin coverage ratio is important.
This article defines and determines the essential repayment capacity measures.
Factors that determine a Borrowers’ Capacity
A borrower’s capacity to pay the debt responsibility on time and the aggregate depends on factors that are both internal and external. The internal factors depend on the company’s characteristics. Such as its ability to generate free cash flow (FCF), the structure of its assets and liabilities, or the amount and maturity of debt on the balance sheet. The external factors depend on industry characteristics, such as the severity of competition or the barriers to entry, and such as the period of the business cycle or the level of interest rates.
Analyzing the Internal Factors
Analyzing the internal factors means evaluating a company’s financials ratios, capital structure, strategy, execution, and competitive position.
Financials and Ratios Analysis
The analysis of a company’s financials and ratios generally involves:
Profitability and cash flow ratios
The analysis normally emphasizes metrics such as profitability margins, return on invested capital, and FCF margins. A company’s ability to settle its debt responsibilities will depend on its ability to generate enough cash. Also, the analysis of FCF and margins allows analysts to recognize if a company is likely going to generate enough resources to pay back its debt.
The more leveraged a company is, the more demanding it will be to find to face debt responsibilities timely and in full amount. The analysis of leverage ratios generally includes debt/equity, FCF/debt, and net debt/EBITDA, debt/capital.
How much principal a company needs to pay back is not the only problem in the estimation of whether a company can face its responsibilities. The interest charged is not the same for each company, and it appreciably affects a borrower’s capacity. That is why the analysis of coverage ratios, such as EBITDA/Interest expense and EBIT/Interest expense, is essential.
Analysts need to evaluate a company’s competitive position through the analysis of many factors. Factors such as the company’s brand power, market share, the level of distinction of its offerings. Versus the pricing power of a company versus its suppliers, customers, and competitors. A company with a secure competitive position will most likely be able to keep profitability and FCF higher than one with an inferior competitive position.
Management Strategy and Execution
A proper analysis of the company’s strategy and track record is also essential. It is crucial to acknowledge some things. Whether the sources of capital used are suitable for the company’s goals and whether there is a dependence on debt versus equity. Whether the strategy is compatible with the company’s strength or whether the company is pursuing expansion in areas where it has low opportunities to add value.
External Factors and Borrower’s Capacity
Some factors have a negligible impact on particular characteristics of the company. The external factors include:
Industry structure must be analyzed by evaluating the number of competitors. The barriers to entry and exit, the power of customers and suppliers, and the threat of substitute products. Such analysis can be completely based on useful frameworks such as Michael Porter’s Five Forces.
Recurrence industries usually experience more turbulent revenue, margins, and FCF. Their performance is largely based on the business cycle and the state of the overall economy. The level of recurrence in the industry should be evaluated, as recurrence industries are usually riskier than non-cyclical ones.
Growth Opportunities in the industry
While strong growth in an industry can usually act as a rising tide that lifts all the boats, short or negative growth opportunities in an industry. It can be more difficult for companies that need to pay off some debt. Inferior competitors can struggle and experience a decline in their capacity.
The state of the overall economy can seriously impact a borrower’s capacity. GDP growth, the level of interest rates, and currency volatility are clear examples of factors. This can affect a company’s ability to pay back its debt responsibilities.
Exceptions to the Ability to Repay Rule
Several types of mortgages are free from the ability to repay rule. Some of these loans comprise timeshare plans, home equity lines of credit, bridge loans, a construction phase of 1 year or less, and reverse mortgages. Loans backed by government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac, are free from debt-to-income essential. Repayment capacity measures are to evaluate the ability of a borrower to repay term debt and replace assets. This article focused on the factors that determine the repayment capacity of loans.