Quick Answer
Leverage metrics measure how much debt the company carries relative to its earnings power and how easily it can service that debt. The three core measures are the interest coverage ratio (EBIT / interest expense), debt to earnings before interest, taxes, depreciation, and amortization (debt / EBITDA), and net debt / EBITDA. They anchor debt-financing capacity for new deals and drive leveraged buyout (LBO) modeling.
After liquidity and profitability comes leverage: how much debt is the company carrying, and can the earnings cover it? Leverage metrics are central to debt-capital-markets work, leveraged buyout (LBO) modeling, and credit ratings.
The Three Core Leverage Metrics
| Metric | Formula |
|---|---|
| Interest coverage ratio | EBIT / interest expense |
| Debt / EBITDA | Total debt / EBITDA |
| Net debt / EBITDA | (Total debt minus cash) / EBITDA |
- Interest coverage tells you how many times current operating profit covers the current interest bill. A coverage ratio of 5x means EBIT could fall 80% before the company couldn't make interest payments
- Debt / EBITDA is a leverage ratio expressed in "turns" of EBITDA. A 4x debt/EBITDA company carries four years of EBITDA in debt
- Net debt / EBITDA is the same idea but subtracts cash, treating excess cash as if it were used to pay down debt overnight
What the Metrics Signal
The same metrics get used to bucket companies into credit categories.
- High coverage and low debt/EBITDA → investment-grade credit
- Low coverage and high debt/EBITDA → leveraged credit (typically rated BB+ and below)
- Very low coverage and very high debt/EBITDA → distressed credit (restructuring or bankruptcy risk)
Think of it this way: Lenders care about two things: can the borrower make the interest payments (coverage) and is the absolute size of the debt manageable relative to earnings (debt/EBITDA)? Both metrics ask the same question (can this company service its debt) from different angles.
Exam Tip: Gotchas
- Interest coverage uses EBIT, not net income. Net income already subtracts interest expense, so using net income would understate the coverage. EBIT shows the profit available BEFORE interest is paid.
- Net debt / EBITDA subtracts cash on top. Same logic as net debt itself: a company with $10 billion of debt and $4 billion of cash has $6 billion of net debt. If EBITDA is $2 billion, net debt / EBITDA is 3x, not 5x.
Why Leverage Metrics Anchor LBO Modeling
Leveraged buyouts (LBOs) load a target with debt at acquisition. The lender's question is whether the target's EBITDA can service that debt over the holding period.
- Initial leverage at close (often 5x-7x debt/EBITDA in current markets) is the most-tested LBO input
- Lenders set covenants based on coverage and leverage ratios that must hold each quarter or year
- Sponsor (private equity firm) returns come from paying down debt with cash flow over the hold period, growing EBITDA, and selling at a higher multiple
The leverage metrics built here feed directly into the LBO valuation work covered later in the unit.