Ability to Pay (Financial Capacity)

Definition

The term ability to pay refers to the capacity of a borrower to successfully make the interest and principal payments on its debts.  A borrower's ability to pay is one of the critical factors lenders evaluate before writing a loan.

Explanation

Also known as financial capacity, a borrower's ability to pay is the most important factor a lender should evaluate before loaning money.   While a borrower's ability to pay can involve a large set of analytical tests; the capacity to service debt is largely a function of the borrower's ability to generate cash.  It is also a function of the borrower's assets that can be readily converted into cash.

One measure that quantifies a borrower's ability to pay is its credit rating.  Firms such as Fitch Ratings, Moody's, and Standard & Poor's specialize in analyzing a borrower's financial statements and assigning a letter grade to the company's outstanding debt.  While all three firms have slightly different rating systems, AAA generally indicates the highest credit quality (investment grade), while D is considered speculative (junk) quality.  Since the likelihood of default is directly related to credit quality, those borrowers with lower ratings will pay the investor-lender a premium, in terms of interest rates than those with higher credit ratings.

Related Terms

liabilities, long-term liabilities, interest expense, deep discount bonds, income bondsgeneral obligation bonds