How do you calculate debt capacity?

Take the cash the business generates in a cautious year before interest and principal: EBITDA less cash tax, maintenance capex and any build in working capital. Divide it by the cover the lender requires to find the yearly debt service the business can carry. Then convert that payment into a loan amount using the rate and term, which for level instalments means multiplying by the annuity factor. If existing facilities stay in place, take their debt service off before dividing by the cover, so what remains sizes only the new borrowing.

What cover ratio do banks use to size debt?

There is no single figure. Each lender sets its own by sector, by the stability of the cash flow and by the kind of loan, and project finance, property investment and corporate lending each work with different levels. A business with contracted income can be sized more tightly than one exposed to commodity prices. The ratio used on this page belongs to its example; the method is the same whatever level a lender chooses.

Why does the loan term change debt capacity so much?

Because each yearly payment includes principal, and a shorter term means more principal each year. The same US$2.56m a year repays a much smaller loan over five years than over ten. Interest rates matter too, but less: in the example, halving the term removes almost US$8m of capacity, while two percentage points on the rate remove US$1.6m. That is why term is often the first thing negotiated when a request exceeds capacity.

Is debt capacity the same as borrowing capacity?

The idea is the same and the inputs differ. Borrowing capacity usually describes a household: how much a lender will advance on a home loan, given income, living costs, other debts and an assessment rate. Debt capacity is the business version, built from the business's own cash flow after tax and the capital spending it cannot avoid. In both, a lender works backwards from what can be repaid, and the security sets a separate ceiling.

// WORKED EXAMPLETHE ARITHMETIC A DECISION RESTS ON

Debt Capacity: a Worked Example

Start from the cash, and the loan is the answer, not the question.

BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED 2026-11-07 · 6 MIN READ

// THE SHORT ANSWER

Ask a lender how much a business can borrow and the honest answer starts from its cash flow, not from the amount requested. Debt capacity is that answer: the largest loan whose interest and repayments the business could meet from its own cash in a cautious year, with a margin left over. The lender sets the cautious cash flow, divides it by the cover it wants, and turns the resulting yearly payment into a loan amount at the rate and term on offer. The term often moves the answer most, which is why a request larger than capacity is often closed, or hidden, by a longer term or a balloon.

BASIS Practitioner judgment from sixteen years in commercial banking, set out in How Bankers Think (Highbank Press, 2026). Every borrower on this site is a composite constructed for teaching, not a client. The market is mid-market commercial lending as practised in New Zealand and Australia; where a convention differs elsewhere, the page says so.

// WORK THE SUM

Every Groundwork file that is a number to work out — cash conversion, debt service cover, expected loss, risk-weighted assets, the margin on a bank's own book — with the working shown in the senior read. One minute each, no signup.

Open The Number →

PART OF Credit Analysis for Beginners

// 01 — WHY A LENDER WORKS BACKWARDS FROM THE CASH

A borrower arrives with a number: the cost of a new line, a purchase price, a refinancing. Testing that number tells the lender whether it fits. Working backwards tells it how far the number could go before it stops fitting, and so how large the gap is and what must fill it: more equity, vendor finance, a smaller project, a longer term, or a repayment left to the end. The capacity figure turns a yes-or-no question into a conversation about structure.

It is one ceiling among several. A lender commonly reads it beside a leverage limit expressed as a multiple of EBITDA and beside the value of its security, and the lowest of them often governs. Capacity built on cash flow is the one that answers whether the loan can be repaid from trading rather than from a sale of the assets.

// 02 — HOW CAPACITY IS CALCULATED

Cash available for debt service = EBITDA − cash tax − maintenance capex ± working capital

(cautious case, before interest and principal)

Debt service it can carry = cash available ÷ cover required

Loan, level yearly instalments = debt service × annuity factor

Annuity factor = (1 − (1 + r)^−n) ÷ r

The cash flow is taken before interest, the lender's version of free cash flow, because the debt service being solved for includes the interest. Four choices then decide the answer. The case: a cautious one, below budget, because capacity sized on the budget is used up by the first poor year. The cover: set by the lender for the business and the sector, so that a fall in cash flow does not leave the instalment unpaid. The rate: the all-in rate, sometimes with a buffer above it, as in a serviceability buffer. And the repayment profile: level instalments, equal principal repayments, which carry less debt because the early payments are higher, or a schedule shaped to the cash flow, as in debt sculpting in project finance. Debt service on facilities the business already has comes off before the new loan is sized.

// 03 — THE EXAMPLE

A flour mill, constructed for this page like every figure in it, asks its bank for US$22m to replace its milling line and refinance its existing debt. Its budget EBITDA is US$6.0m. The bank's cautious case, with lower volumes and a thinner margin on wheat, puts EBITDA at US$5.2m. Cash tax is US$0.7m, maintenance capex US$1.3m, working capital flat. The bank sets cover of 1.25 times for this file. The cover, rates and terms are the example's, not a market norm. In US$m:

Cash available, cautious case: 5.2 − 0.7 − 1.3 = 3.20

Debt service it can carry: 3.20 ÷ 1.25 = 2.56 a year

Rate Term Annuity factor Capacity

6.5% 10 years 7.19 18.4

6.5% 7 years 5.48 14.0

6.5% 5 years 4.16 10.6

8.5% 10 years 6.56 16.8

Budget case, 10 years at 6.5%: (6.0 − 0.7 − 1.3) ÷ 1.25 × 7.19 = 23.0

On the budget, the request fits. On the cautious case over ten years it falls US$3.6m short, and halving the term to five years cuts capacity to US$10.6m. Two points more on the rate, over ten years, take off US$1.6m. The mill's line is the same in every row; only the terms of the loan change.

The gap can be closed in several ways, and each moves risk somewhere. US$3.6m of equity closes it outright. A balloon of about US$6.8m in year ten closes it on paper, since its present value at 6.5% is the missing US$3.6m, by moving that part of the repayment to a refinancing a decade away. A longer term closes it by borrowing from years in which the new line may be wearing out.

// 04 — HOW IT DIFFERS FROM SERVICEABILITY

Serviceability runs the same arithmetic the other way. It starts from a proposed loan, works out its yearly debt service and divides the cash flow by it. On the mill's request, US$22m over ten years at 6.5% costs 22 ÷ 7.19, about US$3.06m a year, and the cautious cash flow of US$3.20m covers that 1.05 times. Capacity and serviceability share the arithmetic; they differ in what they put in front of a credit committee. Serviceability says the request is thin. Capacity says by how much, and what the business could carry instead.

DEFINED IN ONE PARAGRAPH → · DSCR AND HOW BANKS USE IT → · THE LENDER'S FREE CASH FLOW →

// 05 — WHERE IT DECIDES A FILE

Capacity opens the structure section of a credit paper: the request, the capacity, the gap, and how the gap is filled. The credit committee then tests the inputs rather than the arithmetic. Is the cautious case cautious enough for a business exposed to wheat prices? Is US$1.3m the real cost of keeping the mill running, or the owner's hope? Has existing debt service been taken off? Each answer moves the capacity by more than most negotiations over margin.

The term is where the file is usually decided. A term matched to the life of the asset financed lets the cash flow repay the loan; a term stretched past it, or a balloon, asks a lender in a future year to refinance what this one could not. That may be a sound decision, but the paper should say it is being made.

THE DOWNSIDE CASE → · MAINTENANCE CAPEX → · REFINANCING A BUSINESS LOAN →

// QUESTIONS PEOPLE ASK

How do you calculate debt capacity?: Take the cash the business generates in a cautious year before interest and principal: EBITDA less cash tax, maintenance capex and any build in working capital. Divide it by the cover the lender requires to find the yearly debt service the business can carry. Then convert that payment into a loan amount using the rate and term, which for level instalments means multiplying by the annuity factor. If existing facilities stay in place, take their debt service off before dividing by the cover, so what remains sizes only the new borrowing.
What cover ratio do banks use to size debt?: There is no single figure. Each lender sets its own by sector, by the stability of the cash flow and by the kind of loan, and project finance, property investment and corporate lending each work with different levels. A business with contracted income can be sized more tightly than one exposed to commodity prices. The ratio used on this page belongs to its example; the method is the same whatever level a lender chooses.
Why does the loan term change debt capacity so much?: Because each yearly payment includes principal, and a shorter term means more principal each year. The same US$2.56m a year repays a much smaller loan over five years than over ten. Interest rates matter too, but less: in the example, halving the term removes almost US$8m of capacity, while two percentage points on the rate remove US$1.6m. That is why term is often the first thing negotiated when a request exceeds capacity.
Is debt capacity the same as borrowing capacity?: The idea is the same and the inputs differ. Borrowing capacity usually describes a household: how much a lender will advance on a home loan, given income, living costs, other debts and an assessment rate. Debt capacity is the business version, built from the business's own cash flow after tax and the capital spending it cannot avoid. In both, a lender works backwards from what can be repaid, and the security sets a separate ceiling.

// NEXT TO IT

// ON WHOSE DESK

The seats that read this term in an ordinary week. Each page says what the seat is for, who arrives in it, and the shape of the round it runs.

Credit analystReads a borrower and writes the recommendation a decision-maker will act on.
Credit sanctionerHolds delegated authority and signs — or declines — the lending the front line brings.
Portfolio managerOwns the credit on a book after the money is out — reviews, covenants, ratings and early warning.

THE IN-TRAY · ONE MINUTE

Make the call on one file.

A short file on the ground this page covers. Every option opens with how far it sits from a senior banker’s read.

THE CALL · THE LOAN · CAPACITY

A manufacturer wants a five-year loan for a machine. Its own appraisal shows a strongly positive net present value, but the machine saves little cash in years one to three and a lot in years four to eight.

What does the bank need to see?

5 MORE ON THE LOAN · CAPACITY →WHERE DO YOU READ FROM? THE PLACEMENT →

THE READING ROOMIN ONE PARAGRAPHDebt capacity What is debt capacity, and how does a lender work it out from cash flow?