Capacity: How Debt Gets Repaid

Assessing a borrower’s capacity to repay debt can be a very elaborate discussion and the subject of an entire text book. It generally varies based on lending type and term, and the effect of having guarantors always presents a wild card. Like I had mentioned in earlier articles, analysis really can’t be a one-size-fits-all approach, but nearly all credits will have some key things in common.

First we must make an assumption, and perhaps we should refer to it as one of the axioms of credit: Cash flow should be the primary source of repayment! That is a fancy way of saying the repayment of any commercial loan should come from cash generated from that commercial enterprise; therefore, you should first ignore all other factors, like collateral and guarantors, and see if the operating business makes enough money to repay the debt by itself.

How businesses generate cash varies by lending type. The process of a business producing goods and services and receiving cash is referred to as the asset conversion cycle. For example, Widget Inc. manufactures widgets. The business must first use cash to purchase raw materials to form the widgets. Then they must pay for labor to assemble and produce widgets. Once the widgets are complete, they must sell them and wait to collect payment for the sale. Once payment is received, Widget Inc. has cash again, and hopefully, more than when they started! What will they do with this cash? They will either repeat the process all over again, save it for a rainy day, or maybe pay the owners.

Say Widget Inc. gets a big order for widgets, and they use most of their cash to buy materials and pay for production. Now let’s say Widget Inc. gets a second big order before the first order is complete. Widget Inc. has a problem. They used their cash to start production of the first order, so they do not have enough cash to start the second order. Widget Inc. may need to borrow some money to start the second order. This is what we call borrowing cause.

Generally speaking, if a lender wants to give Widget Inc. a loan to fulfill the second order of widgets, then the lender should be repaid when Widget Inc. finally receives payment for selling the widgets. This is a crucial concept. The credit facility should not only match the borrowing cause, but also the timing of cash flow from the asset conversion cycle. This is necessary to increase the odds of repayment.

Where most lenders make painfully long-lived mistakes is by giving a borrower an improperly structured loan. If the loan is not structured to reflect the borrowing cause or timing of the asset conversion cycle, the borrower usually struggles to repay the debt in the long run. Either the borrower will have cash when a loan payment is not due, or a loan payment will be due when the borrower does not have cash. The loan becomes a recurring problem.

To summarize, the loan should be repaid by cash profits (cash flow) of the business. The reason for the loan should have a clearly identified borrowing cause. And, payments should coincide with the timing of cash received from asset conversion cycle. To give the customer a loan that does not coincide with the borrowing cause or asset conversion cycle results in a poorly structured loan.

Lastly, it is import to point out if the expected cash flow will be unable to meet loan payments, generally the loan will not work and should not be granted. You should not try to structure the loan around what the borrower can afford to pay, but you should only structure the loan around what the business should realistically be able to pay and when. Lowering payments to coincide with weak cash flow is referred to as troubled debt restructuring. I shouldn’t have to explain that means you are headed for problems!