Debt Schedule in Financial Modelling

The inability to manage debt is one of the biggest reasons behind the failure of many companies. Just in the past year, giants like Toys R Us and Sears had to file for bankruptcy because they were unable to manage their debt. Leverage is essential in today’s world since it allows a company to expand its business. However, high levels of leverage are also considered to be dangerous. The idea is to manage debt within certain agreed-upon levels.

In this article, we will explain how financial modeling helps in maintaining debt levels.

Segregating the Different Types of Debt

In order to manage debt, it first needs to be segregated. Accountants generally divide debt into two categories viz. long term debt and short term debt. However, financial modelers prefer to create more categories. In most cases, debt is divided into five categories. Short term debt is considered as one category. Long term debt is divided into two categories viz. long term debt which is due in one year and other long term debt. Financial modelers also tend to treat capital leases as long term debt. These leases are also often divided into two categories viz. capital leases due within one year and other capital leases. This detailed categorization aids more accurate financial modeling.

Issuances and Retirements

Companies seldom have stable debt levels. Instead, the total amount of debt they have can be divided into different stages. If a company has been in businesses for a certain amount of time, then they will have some debt which will be about to mature almost every month. In financial terms, this is called “retirement of debt” and reduces the total amount of debt outstanding. From a financial modeling point of view, retirements can be modeled fairly easily. The amounts to be paid for a retirement are constant. Hence, they can simply be hardcoded into the model.

However, many companies do not pay back the debt from their own cash flow. Instead, they prefer to roll over the debt. This means that they pay back old debt with a new one raised at the current interest rate. From a financial standpoint, any introduction of new debt is called issuance. Modeling issuance is slightly more difficult since the amount of debt which may have to be issued is not constant. It may vary based on a number of factors, and retirement is one of them.

Proposed Debt Levels

Modeling the debt structure becomes considerably easy once the proposed debt levels of a company become known. Some companies have a policy wherein they want to maintain a certain percentage of their net worth as debt. Other companies want to reduce their debt to the lowest number possible. If the financial modeler is not a company insider, they have to keep guessing what the debt policy of the company really is. However, there are some companies like Wal-Mart, which clearly mention their proposed debt levels in their annual reports.

Proposed debt levels have a huge impact on the overall financials of the company. The debt level impacts the cash which the company holds on hand, the interest payments which the company has to pay and also the entire net worth of the company. If the company does not directly mention it’s policy on proposed debt levels, the financial modeler must sift through data for several years in the past. An educated guess can be taken based on the actions of the company. However, this information is crucial from a financial modeling perspective.

Even if two companies earn the same amount of profit, the cash flow of a leveraged company can be dramatically different as compared to the cash flow of an unlevered firm.

Deriving the Interest Rates

Just like the proposed debt policy of publicly listed companies has to be derived, the interest rate being paid by the company also needs to be derived. This is because companies do not generally disclose the interest they are paying on their debt unless the debt has been issued publicly.

Determining the interest rate can be done by many methods, including basic ones such as dividing the interest paid by average outstanding debt (beginning balance + ending balance/2). Once the interest rate is derived, it can be used as an input by the financial modeler in order to predict the future outflows pertaining to debt.

Cash Flow Available To Repay Debt

Many times companies state that they want to get rid of their debt as soon as possible. The speed of repayment of debt is dependent upon the free cash flow, which is available to the firm. Financial modelers must ensure that they always display this free cash flow as a separate metric. A good financial modeler accommodates several scenarios with regards to the debt schedule. Financial modelers can assume different rates of repayment of debt to determine whether the company should use the excess cash to pay down debt or whether that money should be invested elsewhere.

The bottom line is that the amount of debt that a company has affects its valuation in several ways. It is for this reason that detailed financial modeling is done and a debt schedule is created. This helps modelers analyze how different levels of debt will impact the company.