Halcott's numbers
Last twelve months, from its filings.
- EBITDA
- $200 million
- Debt and cash
- $900 million and $100 million
- Interest
- $63 million
- Capex and cash taxes
- $50 million and $30 million
- Book equity
- $600 million
Leverage ratios, from credit stats to covenants
Leverage ratios measure how much debt a company carries against what it earns, most often total or net debt ÷ EBITDA. Coverage ratios turn it around: EBITDA, or EBITDA less capex, ÷ interest. Lenders set limits on both in credit agreements, using their own definition of EBITDA. In our first example, $900 million of debt on $200 million of EBITDA is 4.50x leverage and 3.17x interest coverage. Soreno, an AI voice interview practice app for consulting, investment banking and other finance candidates, runs a free debt schedule template with no sign-up, and mock credit and private equity interviews where an AI interviewer asks how much debt a company can carry.
Updated
- Leverage is debt over earnings. Total or net debt ÷ EBITDA, in turns.
- Coverage is earnings over interest. EBITDA ÷ interest, or EBITDA less capex ÷ interest for a stricter test.
- Covenant EBITDA is bigger. Credit agreements add back items that reported EBITDA keeps in.
- Headroom is the real question. How far EBITDA can fall before a covenant trips.
- Twelve questions below. Short answers in our words and the follow-ups to expect.
Leverage ratios in three examples
Halcott Logistics and every number here are invented by Soreno for practice, in millions of dollars, for the last twelve months. It reports under US GAAP and its leases are operating leases.
From the notes
What the credit agreement and lease note add.
- Lease cost in EBITDA
- $30 million
- Lease liabilities
- $240 million
- Synergy add-back
- $25 million
- Restructuring add-back
- $15 million
Example 1: the core credit stats4.50x leverage
1. Total leverage
4.50x
$900 million ÷ $200 million = 4.50x. Bankers say "four and a half turns".
2. Net leverage
4.00x
Take cash off debt: $900 million − $100 million = $800 million, ÷ $200 million = 4.00x. In our experience many agreements test net leverage, and some cap how much cash can be netted.
3. Coverage
3.17x and 2.38x
EBITDA ÷ interest = $200 million ÷ $63 million = 3.17x. Taking capex off first, (200 − 50) ÷ 63 = 2.38x, a stricter view for a company that must keep investing.
4. Debt to capital
60.0%
$900 million ÷ ($900 million + $600 million of book equity) = 60.0%. A balance sheet view, less used in leveraged finance than the earnings ratios.
5. Cash to pay it down
6.3% of debt a year
EBITDA − interest − capex − cash taxes = $200 million − 63 − 50 − 30 = $57 million, with working capital flat. That is 6.3% of debt a year, about 15.8 years to repay it all if nothing changed.
Example 2: covenant EBITDA and leases4.00x or 3.33x?
Halcott's credit agreement, in our example, defines Consolidated EBITDA to add back $25 million of expected cost savings from a recent purchase and $15 million of restructuring charges. Its lease note shows $240 million of operating lease liabilities, and $30 million of lease cost inside EBITDA.
1. Covenant EBITDA
$240 million
$200 million + $25 million + $15 million = $240 million. The SEC staff says a measure calculated differently from EBITDA shouldn't be called EBITDA, so filings label it Adjusted EBITDA or the agreement's own term.
2. Covenant leverage
3.33x
$800 million ÷ $240 million = 3.33x, against 4.00x on reported EBITDA. Same company, same debt. Ask which number an interviewer means.
3. Leases
4.96x lease-adjusted
US GAAP puts operating leases on the balance sheet but books a single lease cost inside EBITDA, so in our experience most credit agreements leave operating lease liabilities out of debt. To compare with an IFRS 16 reporter, add them to debt and the lease cost back to EBITDA: (900 + 240) ÷ (200 + 30) = 4.96x. That treatment is a common analyst convention, not a rule.
4. Which to quote
Say the definition
"4.00x net on reported EBITDA, 3.33x on covenant EBITDA" is a complete answer. "4.00x" alone isn't.
Example 3: headroom and an add-on deal33.3% cushion becomes 23.0%
In our example the agreement caps net leverage at 5.00x on covenant EBITDA and requires at least 2.50x interest coverage. Halcott wants to buy a business with $30 million of EBITDA for $240 million, all borrowed at 8%. The agreement lets it count the target's EBITDA from day one.
1. Breach point today
$160 million
$800 million ÷ 5.00x = $160 million. Covenant EBITDA can fall 33.3% from $240 million before the covenant trips.
2. After the deal
3.85x
Net debt $800 million + $240 million = $1,040 million. Covenant EBITDA $240 million + $30 million = $270 million. $1,040 million ÷ $270 million = 3.85x.
3. New cushion
23.0%
The breach point moves to $1,040 million ÷ 5.00x = $208 million, so EBITDA can now fall only 23.0%. The deal adds debt at 8.00x the EBITDA it brings, above Halcott's 3.33x leverage, so leverage rises and headroom shrinks.
4. Coverage
2.80x
Interest rises by $240 million × 8% to $82.2 million. Our example tests coverage on reported EBITDA, which with the target's is $230 million, so coverage is 2.80x, still above the 2.50x floor.
5. Most it could borrow
$550 million
5.00x × $270 million − $800 million = $550 million of new debt would take it exactly to the limit, with no cushion at all. A sensible answer leaves room.
From SEC staff: non-GAAP financial measures interpretations, FASB: ASU 2016-02, Leases (Topic 842), IFRS Foundation: IFRS 16 Leases and IRS: questions and answers on the business interest limit.
What the interviewer checks on leverage
In our experience the ratios themselves are quick. The questions are about definitions and what the company can survive.
Which ratio, which definition
Total or net, reported or covenant EBITDA, with or without leases. A strong answer names the version.
Cash, not just EBITDA
Capex, cash taxes and interest come before debt paydown. Coverage after capex is the stricter test.
Downside
How far earnings can fall before a covenant trips, and what happens to coverage if rates rise.
Industry context
Stable, asset-light businesses carry more turns than cyclical ones. Say why, not just a number.
12 leverage ratio interview questions
The short answers are ours. The note says what a strong answer adds.
The ratios4 questions
What are the main credit ratios, and what does each tell you?
Show follow-ups
Short answer. Leverage, debt ÷ EBITDA, is how many years of earnings the debt equals. Coverage, EBITDA ÷ interest, is how easily earnings pay interest. Free cash flow ÷ debt is how fast it can be paid down.
Gives one number for each on a company you know.
Why use net debt instead of total debt?
Show follow-ups
Short answer. Because cash could repay debt today. Net debt shows the burden after that. Lenders sometimes cap how much cash counts.
Says when net leverage flatters: cash that is trapped abroad or needed to run the business.
Why look at EBITDA less capex coverage?
Show follow-ups
Short answer. Because a capital-heavy company can't skip capex to pay interest. It is a stricter test of what is really available.
Names an industry where the gap is large.
What is a fixed charge coverage ratio?
Show follow-ups
Short answer. Earnings available for fixed charges, such as interest, required debt repayments and sometimes rent, divided by those charges. Each credit agreement defines it.
Says that the exact definition comes from the agreement, not a textbook.
Debt capacity4 questions
How do you decide how much debt a company can support?
Show follow-ups
Short answer. From its cash flow and risk: the leverage and coverage lenders will accept for its industry, with room for a bad year.
Works one limit through on numbers. Practice it, see a model answer
What kinds of debt are used in an LBO?
Show follow-ups
Short answer. Senior secured loans first, then high-yield bonds or other junior debt, sometimes mezzanine, each with its own leverage level.
Says senior and total leverage separately. Practice it, see a model answer
What makes a company a good LBO candidate?
Show follow-ups
Short answer. Steady cash flow, low capex needs, a solid market position and room to improve. Those let it carry more turns of debt.
Links each trait to a ratio. Practice it, see a model answer
What is a cash sweep?
Show follow-ups
Short answer. A requirement that excess cash repays debt. It brings leverage down faster.
Says how the sweep changes leverage by exit. Practice it, see a model answer
Definitions and accounting4 questions
How does covenant EBITDA differ from reported EBITDA?
Show follow-ups
Short answer. Credit agreements add back items such as expected cost savings, restructuring and one-offs, so covenant EBITDA is usually higher and covenant leverage lower.
Says why lenders care how aggressive the add-backs are.
How do leases affect leverage ratios?
Show follow-ups
Short answer. Under IFRS 16 lease cost sits below EBITDA and lease liabilities are on the balance sheet. Under US GAAP operating leases are on the balance sheet too, but their cost stays inside EBITDA. Put companies on one basis before comparing.
Shows the lease-adjusted ratio.
What is EBITDA, and why do bankers use it?
Show follow-ups
Short answer. Earnings before interest, taxes, depreciation and amortization: a rough measure of operating cash earnings before financing, so it suits ratios about debt.
Names its blind spots: capex, working capital and taxes. Practice it, see a model answer
Is all interest tax deductible?
Show follow-ups
Short answer. Not always. In the US, section 163(j) caps deductible business interest at business interest income, 30% of adjusted taxable income and floor plan financing interest, with the rest carried forward.
Says what that does to after-tax interest for a highly levered company.
More to prepare with
Common leverage ratio mistakes
Quoting a ratio without its definition
Halcott is 4.00x or 3.33x depending on the EBITDA. Say which.
Mixing lease bases
Lease liabilities in debt need the lease cost added back to EBITDA, or the ratio is inflated.
Using EBITDA as cash
Halcott's $200 million of EBITDA leaves $57 million after interest, capex and tax.
Forgetting headroom
The question is often how much EBITDA can fall, not just today's ratio.
A rule-of-thumb leverage as fact
Acceptable turns depend on the industry, the rate environment and the lender. Give a range and the reason.
Size the debt out loud
Soreno's AI interviewer gives you a company's numbers, asks for leverage and coverage, then asks how much more it could borrow. You get a scored report on your answer.
Questions people ask
What is a good debt to EBITDA ratio?
It depends on the industry and the lender. A stable, asset-light company can carry more turns than a cyclical one. In interviews, give the ratio, then say why it is high or low for this business.
What is the difference between total and net leverage?
Total uses all debt. Net subtracts cash. Net is lower whenever the company holds cash.
Is EBITDA a GAAP measure?
No. The SEC staff covers it in its non-GAAP interpretations: earnings in EBITDA means GAAP net income, and a measure calculated differently should carry another name, such as Adjusted EBITDA.
Do companies disclose covenant EBITDA?
Sometimes. The SEC staff says that if a covenant is material, a company may be required to disclose the measure as the credit agreement calculates it in its MD&A, even when it excludes charges that would otherwise keep it out of a filing.
Are operating leases debt?
Under US GAAP since ASU 2016-02, operating leases put a right-of-use asset and a lease liability on the balance sheet, but the cost is a single lease cost. IFRS 16 treats all leases like finance leases. Whether to count lease liabilities as debt in a ratio is a choice, so say which you made.
How does a rate rise change the ratios?
Leverage doesn't move, since debt and EBITDA are the same. Coverage falls, and so does free cash flow to repay debt.