Debt and leverage
How net debt is calculated, what net debt to EBITDA and interest cover measure, why leverage magnifies both directions, and when debt becomes a problem.
Key points
- Net debt is borrowings less cash, and it is the figure an acquirer assumes and the one enterprise value uses.
- Leverage does not create risk on its own. It magnifies whatever the business does, in both directions.
- The binding constraint is usually refinancing, not the ratio: debt has to be repaid or rolled on a date.
Gross debt and net debt
Gross debt is everything borrowed: bank facilities, bonds, and under current accounting standards lease obligations. Net debt subtracts cash and short-term investments, on the reasoning that a company holding $400m of cash against $1bn of borrowings owes $600m in substance.
Net debt is the figure used in enterprise value and in most leverage ratios. It can be negative, which describes a company holding more cash than debt.
The subtraction assumes the cash is available, and it is not always: cash held in subsidiaries abroad, or set aside against a specific obligation, cannot simply repay a bond. The distinction rarely matters and occasionally matters a great deal.
The measures that get used
Four ratios cover most of what is asked about a balance sheet, and each answers a different question. Two are about the size of the debt and two are about whether it can be serviced.
The rough levels below are conventions used by lenders rather than thresholds with any authority, and they differ by industry: a utility with contracted revenue supports leverage that would be reckless at a semiconductor company.
| Measure | Calculation | Question it answers | Often described as high |
|---|---|---|---|
| Net debt to EBITDA | Net debt divided by EBITDA | How many years of operating profit the debt represents | Above 3x |
| Debt to equity | Total debt divided by shareholders equity | How the company is funded | Above 2x, and meaningless if equity is negative |
| Interest cover | Operating profit divided by interest | Whether profit covers the interest bill | Below 3x |
| Current ratio | Current assets over current liabilities | Whether the next year can be met | Below 1x, depending on the industry |
Why leverage cuts both ways
Debt is a fixed claim. Interest is owed whatever the business earns, so the equity holder takes what is left after a payment that does not move.
That is what magnifies returns. A company earning 10% on assets funded half by debt at 5% earns more than 10% on its equity, and the same structure turns a modest fall in operating profit into a large fall in what owners receive. Return on equity rises with borrowing for exactly this reason, which is the caveat that matters most about that ratio.
The effect is invisible while trading is stable and decisive when it is not. It is why leverage is discussed in terms of what a business does in a downturn rather than what it earns now.
When does debt become a problem?
Usually on a date rather than at a level. Debt matures, and a company that cannot repay must refinance at whatever rate is available, so the risk concentrates around maturities rather than around the ratio.
A company at 4x net debt to EBITDA with nothing due for five years is in a different position from one at 2x with a bond maturing next year into a market that has closed. The maturity profile appears in the notes and is the part of the picture the ratios cannot show.
Covenants are the second trigger. Loan agreements typically require ratios to stay within limits, and breaching one hands the lender rights regardless of whether payments have been made. That is how a company can be solvent, paying, and still in default.
The third is the type of debt. Floating-rate borrowing reprices as rates move, so an interest bill can grow without the company borrowing another dollar.
Where the numbers are
The screener carries Net Debt to EBITDA, Long term debt, Lease obligations, Cash and Current ratio as filters, and Debt Growth for the change over time.
Debt growth against revenue growth is the comparison worth making. Borrowing that grows with the business is funding it; borrowing that grows while revenue does not is funding something else, often a dividend or a buyback the cash flow could not cover.
Common mistakes
Comparing leverage across industries, where the tolerable level is set by how stable the revenue is.
Using EBITDA as though it were the cash available to service debt, when it is stated before interest, tax and the capital spending that keeps the business running.
Reading a debt-to-equity ratio at a company with negative equity, where the number is arithmetic rather than information.
Ignoring lease obligations, which are debt in substance and now sit on the balance sheet.
Treating a low ratio as safety without looking at when the debt is due.
Educational information about how these figures are constructed. Not investment advice, and not a recommendation to buy or sell any security.
