The Leverage and Coverage Ratios Lenders Use
Lenders boil a company's creditworthiness down to a handful of ratios — how much debt it carries relative to its earnings, and how comfortably its earnings cover its debt payments.
Prerequisites: Debt Capacity and Coverage-Based Debt Sizing
Lenders and rating agencies size up a borrower's risk using a small toolkit of ratios that reduce the entire balance sheet and income statement to a few comparable numbers. Two families do almost all of the work: leverage ratios, which ask how much debt is piled on top of the business, and coverage ratios, which ask how easily current earnings can service that debt. They answer different questions, and a company can look fine on one while flashing red on the other.
Leverage ratios measure the stock of debt relative to earnings power (how big is the pile). Coverage ratios measure the flow of earnings relative to debt payments (can it keep servicing the pile). Both are needed, because a company can carry a modest debt pile it still can't service, or a large pile it services comfortably.
The two families
In words: how many years of current EBITDA it would take to pay off all outstanding debt, holding earnings constant. A ratio of 2x is conservative for most industries; 6x or higher is typical of a leveraged buyout and signals a thin margin for error.
In words: how many times over the company's operating cash flow covers its interest bill. A related version, fixed charge coverage, adds scheduled principal repayments and lease payments to the denominator, giving a stricter test of whether cash flow covers all mandatory outflows, not just interest.
Worked example
Compare two companies, both with $300 million of debt and a 6% average interest rate (so both owe $18 million of interest a year).
- Company A: EBITDA of $150 million. Leverage ratio: . Interest coverage: . Comfortable on both counts.
- Company B: EBITDA of $50 million. Leverage ratio: . Interest coverage: . Same debt pile, but relative to earnings it is three times as levered and covers interest at barely a third of Company A's cushion.
Both carry identical debt in dollar terms; the ratios reveal that Company B is a materially riskier credit, because its earnings base is much smaller relative to the obligations sitting on top of it.
What this means in practice
Credit agreements routinely write these exact ratios into loan covenants, requiring a borrower to stay below a maximum leverage ratio and above a minimum coverage ratio throughout the loan's life, tested quarterly. Rating agencies use the same pair, alongside qualitative factors, to set corporate credit ratings — moving from investment grade to high yield is largely a story of these ratios crossing certain thresholds.
Ratios calculated from reported EBITDA can be gamed — companies routinely present "adjusted EBITDA" that strips out real recurring costs (stock compensation, restructuring charges that keep recurring, certain one-time items that aren't actually one-time). A leverage ratio that looks conservative on adjusted EBITDA can look considerably worse recalculated on unadjusted numbers.
Related concepts
Practice in interviews
Further reading
- Standard & Poor's, Corporate Ratings Criteria
- Rosenbaum & Pearl, Investment Banking (ch. on credit analysis)