Factors explaining debt capacity

The purpose of this paper is to provide empirical support for micro‐economic theory respecting debt capacity and develop a practically useful model for assessing debt capacity for firms seeking to minimize credit risk and the cost of debt (interest rate).

Theoretically important factors explaining the variation in debt capacity are identified and tested, namely: the proportion of property, plant and equipment over total assets, industry group (highlighting asset specificity), sales variability, and the depreciation method. Data were collected from the SEC Disclosure Database. Using the SPSS software, this paper's theoretically based constructs were tested by developing a linear regression model.

The regression results indicate that the theoretical model explains a statistically significant portion of the variation across firms in the proportion of debt to total assets a firm is willing (and is allowed by the financial market) to carry. However, a major portion of the variation in debt capacity is not explained. Future research can identify and test other factors to develop a better explanatory model.

Subject to the above limitation, the model developed provides a basis for firms to assess their debt capacity. Firm's whose actual debt to asset ratio is less than their debt capacity can borrow more if needed and if additional leverage is justified. Creditors can also use the estimated debt capacity when deciding the terms (including the interest rate) of extending credit. Investors can shy away from companies with very little or no unused debt capacity to reduce their portfolio risk.

This paper's academic and practical contributions, respectively, are to empirically test debt capacity's theoretical constructs and provide a practically useful and theoretically based model for assessing debt capacity by creditors, investors, and the companies.