Long-Term Debt-Repayment Ability
Financial stability, like the soundness of any building, is predicated on a solid foundation—the ability to pay debt. As such, it is important for businesses, large and small, to have a good understanding of their capabilities for repaying long-term debt. Such debt usually has a repayment term of more than one year and can take the form of bank loans, bonds, venture debts, and other financial instruments.
The ability to pay long-term financial obligations is often described as debt-repayment capacity or debt-repayment capability. A company with strong debt-repayment capacity is theoretically able to meet its future financial liabilities from the cash generated from its day-to-day activities. This is because debt repayment depends on the profitability of the firm, as well as its access to external sources of finance. Additionally, a company can reduce its risk of default and increase its creditworthiness if it can demonstrate that it can generate sufficient financial resources to pay its long-term debt.
A companys debt-repayment capacity is largely determined by its overall financial situation. To evaluate the health of a company’s long-term debt-repayment capacity, a number of financial ratios can be analyzed.
The solvency ratio, also known as the debt-paying ability ratio or the debtor-creditor ratio, is calculated by dividing the firm’s total liabilities (including both short-term and long-term debt) by its total assets and expressing it as a percentage.
For example, if a company has total liabilities of $4,000 and total assets of $10,000, its solvency ratio is (4,000/10,000) x 100 = 40%. Companies that can maintain a solvency ratio of 40% or higher are viewed favorably by creditors and investors.
The debt coverage ratio is also an important measure of the companys long-term debt repayment capacity. This ratio measures a companys ability to pay all its debt obligations - including both interest and principal - from its net operating income or profit. To calculate the debt coverage ratio, the businesss net operating income is divided by its total debt service obligation (including both interest and principal). For example, if a company has net operating income of $500,000 and $200,000 in debt service obligations, its debt coverage ratio is (500,000/200,000) x 100 = 250%. Generally, a debt coverage ratio of 150% or higher is desired by creditors.
The cash flow to debt ratio measures a companys ability to generate enough cash from its regular activities, usually through operations and sales, to meet its current debt obligations. This ratio is calculated by dividing the businesss total cash flow from operations by its total current liabilities. A ratio of 1.5 or more indicates that the company is generating sufficient cash flow to cover its short-term debt obligations.
In addition to these standard measures, it is also important to review the companys past track record in paying its debt obligations. Companies with a history of punctual payments and no formal defaults in their past borrowing history are generally perceived as having good long-term debt-repayment capacity.
The companys access to external sources of funding such as bond issuances, equity issues, etc., may also influence its ability to pay long-term debt. Companies that can demonstrate a consistent record of successful external fund-raising activities, or a strong financial position, are generally considered to have better long-term debt-repayment abilities.
Finally, it is important to review the terms and conditions of the long-term debt obligations. The repayment obligation should typically be realistic and achievable and should not be so large as to impose an excessive burden on the company.
The soundness of a companys long-term debt-repayment capacity is an important factor in its financial success and stability. Analyzing the companys financial information, access to fund-raising sources, and terms of the long-term debt obligation can provide useful insight into its debt-service ability and should be pursued as part of a regular financial assessment.
