What are the key steps to incorporating debt into a financial model?

1 Identify debt types and sources

The first step to incorporating debt into a financial model is to identify the types and sources of debt that the business or project can access. Debt can be classified into different categories based on the maturity, seniority, security, cost, and flexibility of the debt. Some common types of debt are short-term debt, long-term debt, revolving credit, term loans, bonds, leases, and mezzanine debt. The sources of debt can vary depending on the size, industry, and creditworthiness of the business or project, as well as the availability and cost of capital in the market. Some common sources of debt are banks, financial institutions, bond markets, private lenders, and equity holders.

2 Calculate debt schedule and interest expense

The second step to incorporating debt into a financial model is to calculate the debt schedule and interest expense for each type and source of debt. The debt schedule is a table that shows the opening balance, drawdowns, repayments, and closing balance of each debt item over the forecast period. The interest expense is the amount of interest that the business or project has to pay on the outstanding debt balance in each period. The interest expense can be calculated based on the interest rate, the frequency of compounding, and the payment terms of each debt item. The interest expense can be fixed or variable depending on whether the interest rate is constant or linked to a benchmark rate.

3 Adjust income statement, balance sheet, and cash flow statement

The third step to incorporating debt into a financial model is to adjust the income statement, balance sheet, and cash flow statement to reflect the impact of debt on the financial performance and position of the business or project. The income statement needs to deduct the interest expense from the earnings before interest and taxes (EBIT) to get the earnings before taxes (EBT), and then apply the tax rate to get the net income. The balance sheet needs to show the current and non-current portions of the debt balance as liabilities, and adjust the equity for any changes in retained earnings or dividends. The cash flow statement needs to show the cash inflows and outflows from financing activities, such as borrowing, repaying, or paying interest on debt.

4 Evaluate debt capacity and coverage ratios

The fourth step to incorporating debt into a financial model is to evaluate the debt capacity and coverage ratios of the business or project. The debt capacity is the maximum amount of debt that the business or project can sustain without jeopardizing its solvency or liquidity. The debt coverage is the ability of the business or project to generate enough cash flow to service its debt obligations. Some common debt capacity and coverage ratios are the debt-to-equity ratio, the debt-to-EBITDA ratio, the interest coverage ratio, the debt service coverage ratio, and the fixed charge coverage ratio. These ratios can be compared to the industry benchmarks, the debt covenants, and the target capital structure to assess the optimal level and mix of debt for the business or project.