# Debt capacity and the ratios that set borrowing limits
In December 2013, Detroit filed the largest municipal bankruptcy in US history with roughly $18 billion to $20 billion in debt and unfunded liabilities (estimate, City of Detroit bankruptcy filings). Bondholders, retirees, and residents all wanted the same answer to a question that should have been asked years earlier: how much debt could this city actually carry? This lesson gives you the ratios that answer that question before a crisis, not after.
Debt capacity is the maximum amount of debt an entity can take on while still reliably servicing it (paying scheduled principal and interest) without cutting essential services or breaching legal limits. For a city, region, or public utility, this isn't abstract. It determines credit ratings, borrowing costs, and ultimately whether a hospital, transit line, or school gets built.
Two rating agencies dominate this space for public debt: S&P Global Ratings and Moody's Ratings. Both publish methodologies scoring municipal and sovereign sub-national borrowers, and both lean heavily on the ratios below.
DSCR measures how many times over an entity's available revenue covers its annual debt payments (principal plus interest, called "debt service").
Formula:
DSCR = Net Operating Revenue ÷ Annual Debt Service
Worked example: A municipal water utility generates $12 million in net operating revenue (revenue minus operating expenses, before debt payments) and owes $8 million in annual debt service on its bonds.
DSCR = $12,000,000 ÷ $8,000,000 = 1.5x
This means the utility earns 1.5 times what it needs to cover its debt payments. Most revenue bond covenants (bonds repaid from a specific revenue stream, like water fees or toll income, rather than general tax power) require a minimum DSCR of 1.20x to 1.25x. Investment-grade municipal utility bonds commonly target 1.5x to 2.0x as a healthy cushion (estimate, typical US municipal bond covenant ranges per Municipal Securities Rulemaking Board disclosures).
Fall below the covenant threshold and the issuer risks default triggers, rate covenants forcing fee increases, or a rating downgrade.
Debt per capita divides total outstanding debt by population. It's the simplest cross-city comparison tool, though it ignores income levels and economic base.
Formula:
Debt per Capita = Total Outstanding Debt ÷ Population
Worked example: A mid-sized US city carries $450 million in general obligation debt (debt backed by the full taxing power of the government, called GO debt) and has a population of 300,000.
Debt per Capita = $450,000,000 ÷ 300,000 = $1,500 per resident
For context, Moody's and the Lincoln Institute of Land Policy have noted that US city GO debt per capita commonly ranges from roughly $500 to $3,000, with large legacy cities (Chicago, Detroit-era, Philadelphia) often exceeding $3,000 to $5,000 (estimate, varies significantly by city and year, always check current issuer disclosures). There is no single legal ceiling nationally; limits are typically set by state constitutions or statutes, often as a percentage of assessed property value (commonly 10 to 15 percent in many states).
This is the ratio most non-specialists miss, and it's often where hidden risk hides.
Overlapping debt is debt issued by other governmental entities that share the same tax base as the primary issuer, school districts, counties, water authorities, that a resident is also on the hook for through separate tax levies.
If you only look at city debt, you underestimate the real burden on that city's taxpayers.
Worked example: A city has $450 million in direct GO debt. Overlapping entities serving the same residents include:
Total overlapping debt = $500 million
Total direct + overlapping debt = $450M + $500M = $950 million
Recalculated per capita: $950,000,000 ÷ 300,000 = $3,167 per resident, more than double the direct-debt-only figure.
Rating agencies always assess overlapping debt. The GFOA (Government Finance Officers Association) publishes best practices requiring disclosure of overlapping debt in official statements for bond issuances.
Many US states cap GO debt at a fixed percentage of a city's assessed property value, commonly 10 percent (varies by state constitution). The legal debt margin is simply the gap between the cap and current debt outstanding.
Legal Debt Margin = (Debt Limit % × Assessed Valuation) − Outstanding Debt Subject to Limit
If assessed valuation is $5 billion and the state cap is 10 percent, the debt limit is $500 million. If the city already carries $450 million subject to that limit, its legal debt margin is just $50 million, a tight cushion for new borrowing.
Europe generally doesn't use per capita debt limits the same way. Instead, national and EU-level frameworks matter more:
Eurostat publishes comparable general government debt-to-GDP data across member states; as of recent estimates, EU average general government debt-to-GDP hovers in the 80 to 90 percent range (well above the 60 percent Maastricht reference, a persistent gap since the 2008 and 2020 crises). Check the Eurostat government finance statistics database for current figures.
Knowledge check
1. A revenue bond covenant requires a minimum DSCR of 1.25x. What does this covenant primarily protect against?
2. A utility's DSCR falls from 1.8x to 1.1x over three years, even though its debt service payments stayed flat. What does this trend most likely indicate?
3. Why do rating agencies like S&P and Moody's rely heavily on DSCR and similar ratios when scoring municipal borrowers, rather than just looking at total debt outstanding?
4. Select ALL correct answers about how DSCR is calculated and interpreted.
Select all the correct answers.
5. Select ALL correct answers about why debt capacity analysis matters for entities like cities and public utilities.
Select all the correct answers.
No single ratio tells the full story. A city might have low debt per capita but a weak DSCR if its revenue base is shrinking (population decline, deindustrialization). Conversely, high overlapping debt with strong DSCR and growing assessed values may still be manageable.
Analysts typically triangulate:
1. DSCR for immediate repayment safety margin on a specific bond or fund.
2. Debt per capita (direct and overlapping) for taxpayer burden comparison across peers.
3. Debt-to-assessed-value or debt-to-GDP for legal and structural capacity relative to the local economy.
S&P and Moody's rating reports (many freely accessible via issuer investor relations pages) show exactly how professionals blend these into a single letter grade, from AAA down through speculative grades.
For anyone modeling this in a spreadsheet or script, the core logic is simple:
dscr = net_operating_revenue / annual_debt_service
debt_per_capita = total_debt / population
total_burden_per_capita = (direct_debt + overlapping_debt) / population
if dscr < 1.25:
flag = "below typical covenant threshold"This isn't a valuation model, it's a screening tool. Real credit analysis layers in trend data (5 to 10 years), revenue volatility, and legal covenant language.