Leverage Metrics

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.

What Are the Three Core Leverage Metrics?

• 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 Do the Metrics Signal About Credit Quality?

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 (a weaker credit profile; the ratios signal credit quality but do not by themselves set a rating)
• 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 Do 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, expressed in turns of debt/EBITDA, 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.

How Do You Calculate Leverage After a Proposed Transaction?

Use post-transaction debt, cash, earnings and interest. Borrowing changes debt immediately, but cash stays higher only if the borrower keeps the proceeds. If it spends the borrowing on an acquisition, do not subtract the spent proceeds as cash still on hand.

Suppose debt is $500 million, cash is $80 million, and EBITDA is $100 million after a $10 million expense that the credit agreement permits as an add-back. The company borrows and spends another $100 million.

Ignoring target earnings, adjusted EBITDA is $110 million and net debt is 600 − 80 = $520 million. Net leverage is 520 / 110 = 4.73 times. Add-backs require support in the stated covenant definition; they are not automatic.

Solve for debt headroom. A 4.0 times total-debt cap and $105 million adjusted EBITDA allow $420 million total debt. With $300 million already outstanding, additional capacity is $120 million, assuming no other constraints. The maximum total balance is not the same as additional borrowing.

Update interest coverage. If EBIT remains $80 million, existing interest is $12 million and new borrowing adds $8 million annual interest, coverage is 80 / (12 + 8) = 4.00 times. Do not subtract interest from EBIT before calculating an EBIT-based coverage ratio.

Avoid counting cash proceeds twice. If a $30 million nonoperating asset sale funds immediate debt repayment, debt falls by $30 million and cash returns to its previous balance. In the absence of tax or other changes, net debt falls by $30 million, not $60 million.

What Should You Check on Exam Day?

• Recall interest coverage uses EBIT, not net income, in the numerator.
• Remember net debt/EBITDA subtracts cash from total debt before dividing by EBITDA.
• Connect high coverage and low debt/EBITDA to investment-grade credit; the opposite signals leveraged or distressed credit.
• Read LBO leverage at close in turns of debt/EBITDA, and apply the leverage figure the scenario gives you.