5.2 Leverage, Coverage, and Credit

Leverage Is a Stock; Coverage Is a Flow

Leverage asks how much of the firm is financed with debt. Coverage asks whether this period's operating profit can service the contractual payments on that debt. CFI's Financial Analysis Fundamentals treats both families because a company can look modestly levered on the balance sheet and still be one weak quarter from missing interest, or the reverse: high debt/EBITDA with so much cash generation that coverage is comfortable.

Keep Northline's Year 1 capital structure and earnings in front of you:

Total debt for these ratios is interest-bearing debt: revolver + current portion + long-term debt. Do not include accounts payable or accrued expenses; those are operating liabilities already inside NWC. Net debt subtracts cash (and often short-term investments). Northline net debt = $270,000 − $120,000 = $150,000.

Debt/Equity and Debt/Capital

Debt/equity = Total debt / Book equity

Northline: $270,000 / $400,000 = 0.675x. For every dollar of book equity there is 67.5 cents of interest-bearing debt. This ratio is sensitive to accounting equity: buybacks shrink the denominator and make the firm look more levered without a new borrowing; a large retained-earnings balance does the opposite.

Debt/capital = Total debt / (Total debt + Equity)

Northline: $270,000 / ($270,000 + $400,000) = $270,000 / $670,000 = 40.3%. Capital here means the invested capital of debt plus equity, not current operating liabilities. A 40.3% debt share is the same capital structure as 0.675x debt/equity; they are two presentations of one mix. If a case adds preferred stock, put preferred in the capital denominator (and usually treat it as a debt-like claim for net debt in valuation).

Exam trap: using net debt in the debt/equity ratio without being asked. Debt/equity and debt/capital are usually gross unless the question says net. Net debt belongs with EV multiples and with net-debt/EBITDA.

Debt/EBITDA Versus Interest Coverage

Debt/EBITDA = Total debt / EBITDA

Northline: $270,000 / $190,000 = 1.42x. Read it as "1.42 years of this year's EBITDA to retire the debt stock if EBITDA were all cash and all dedicated to principal." It is not a repayment schedule. It is a standardized leverage multiple that lenders, rating screens, and comps all use because EBITDA is before capital structure and non-cash D&A.

Net debt/EBITDA = $150,000 / $190,000 = 0.79x. Use net when the firm holds material cash that could theoretically pay down debt. A company with $270,000 of debt and $120,000 of surplus cash is not in the same credit box as a company with $270,000 of debt and $5,000 of cash.

Interest coverage = EBIT / Interest expense

Northline: $150,000 / $25,000 = 6.0x. This year's operating profit covers this year's interest six times. That is a flow-to-flow test. Debt/EBITDA can look fine while coverage collapses if the debt is expensive, and coverage can look fine while debt/EBITDA is high if the coupon is low.

EBITDA interest coverage = $190,000 / $25,000 = 7.6x. Some credit agreements use EBITDA because they add back D&A; some use EBIT because depreciation is a real economic cost of the asset base that must eventually be replaced. On the FMVA final, read the definition in the case. If the question says interest coverage with no qualifier, default to EBIT / interest, which is the textbook ratio.

Worked contrast: suppose Northline refinanced into $400,000 of 10% debt. Interest would be $40,000. EBITDA might still be $190,000 (debt/EBITDA = 2.11x, still not extreme), but EBIT coverage would fall to $150,000 / $40,000 = 3.75x. Leverage and coverage moved in the same direction here, but not one-for-one. Always compute both.

Fixed-Charge Coverage

Interest is not the only contractual outflow. Fixed-charge coverage (FCC) brings in other unavoidable charges, most often operating lease or rent payments. A common form is:

FCC = (EBIT + lease payments) / (Interest + lease payments)

Lease payments go in the numerator because EBIT is after rent on an income statement that expensed the lease; adding rent back puts a rent-inclusive operating profit over the full fixed-charge load. Northline cash leases (rent) = $20,000:

FCC = ($150,000 + $20,000) / ($25,000 + $20,000) = $170,000 / $45,000 = 3.78x

Some agreements also put mandatory principal amortization, preferred dividends, and letter-of-credit fees in the denominator, sometimes on an after-tax basis for equity-like charges. There is no single official formula and no CFI-published pass/fail number. If a case gives a credit agreement, use that agreement's definition. If it does not, use EBIT / interest for interest coverage and the EBIT-plus-leases form above for FCC, and say which definition you used.

Do not invent a "CFI official covenant threshold" such as 3.0x maximum Debt/EBITDA. CFI teaches the ratios; lenders negotiate the caps. Market deals often land in a range that varies by sector, cyclicality, and seniority. The exam skill is computing the ratio correctly and spotting the direction (leverage up, coverage down), not reciting a universal covenant.

Why Enterprise Value Multiples Use Net Debt

Enterprise value (EV) is the value of core operations available to all capital providers. The standard bridge from equity value is:

EV = Equity value + total debt + preferred + NCI − cash (and non-core investments, as applicable)

In the simple two-claim case:

EV = Equity value + net debt, where net debt = total debt − cash

Suppose Northline's equity value (market capitalization, not the $400,000 book equity) is $500,000. Then:

EV = $500,000 + $270,000 − $120,000 = $650,000

EV / EBITDA = $650,000 / $190,000 = 3.42x

If you added gross debt and ignored cash, you would get $500,000 + $270,000 = $770,000 and $770,000 / $190,000 = 4.05x. That overstates the operating multiple. The $120,000 of cash is already inside equity value — shareholders own it — so adding debt without subtracting cash treats the firm as if operations cost $770,000 when $120,000 of the equity value is just cash sitting on the balance sheet.

Subtracting cash is the same idea as using net debt. You are stripping a non-operating asset out of EV so EV / EBITDA compares operations to operating earnings. That is why trading comps and DCF bridges both use net debt, and why a firm with a huge cash pile can have low (even negative) net debt without being "debt free" on a gross basis.

Exam trap: substituting book equity for equity value in the EV bridge. Northline book equity is $400,000; the illustrative market value was $500,000. EV is a market concept. Use the case's market cap or implied equity value, then add net debt from the latest balance sheet (and watch for cash that is trapped or restricted).

Credit Red Flags the Exam Actually Tests

You will not assign a Moody's rating on the FMVA final. You will be asked which development is a credit concern, or which adjustment belongs in net debt. Use this working list:

• Leverage up, coverage down. Debt/EBITDA rising while EBIT / interest is falling toward 2x or 1x. Northline at 1.42x and 6.0x is comfortable; the red flag is the path, not a magic cutoff.
• CFO that cannot cover cash interest. Accrual coverage of 6.0x means little if cash from operations is $10,000 and cash interest is $25,000.
• Revolver fully drawn and cash declining. Liquidity is being used, not held.
• Current ratio collapsing because of a debt balloon. A large current portion of long-term debt dumps long-term debt into current liabilities. Operating NWC is unchanged (debt stays out of NWC), but the current ratio and any current-ratio covenant can break overnight.
• Days going the wrong way in distress. DSO up (customers stalling), DIO up (stock not selling), DPO up (the firm stalling vendors). A shorter CCC from DPO stretch can be a distress signal, not efficiency.
• Customer or supplier concentration, covenant waivers, going-concern language, delayed filings. Qualitative, still credit.
• Earnings quality. Net income up, CFO down. That is Section 5.3, and it is a credit input because debt is serviced with cash.

Off-Balance-Sheet Obligations, Conceptually

Off-balance-sheet (OBS) claims are economic obligations that do not (or did not) appear as debt on the face of the balance sheet. Credit analysis still counts them when they are contractual and material.

Under ASC 842 and IFRS 16, most leases are now on the balance sheet as a lease liability plus a right-of-use asset. Pre-standard operating leases were the classic OBS item: rent in EBIT, no debt in the leverage ratio, which understated Debt/EBITDA. If a case still gives undiscounted operating-lease commitments in the footnotes, a credit-side adjustment is to capitalize them (a simple method is rent × a multiple, or the disclosed present value) and add that liability to debt. Do not pretend IFRS 16 ended the topic. Short-term leases, variable payments, and residual-value guarantees can still sit off-balance-sheet.

Other OBS items to recognize on sight, without needing a full accounting course:

• Take-or-pay and other purchase commitments — future cash that is not inventory yet
• Guarantees and keep-well agreements — someone else's debt that can become yours
• Unfunded pensions and other post-employment benefits — debt-like, often added to net debt in valuation
• Litigation and environmental contingencies — disclosed, sometimes accrued, sometimes not
• Receivables factoring or securitization with recourse — AR may have left the balance sheet while the risk did not

You are not asked to invent a capitalization multiple on the FMVA final unless the case gives one. You are asked not to treat face-value total debt as the complete claim set when the footnotes are screaming about leases, pensions, or guarantees.

Putting the Ratios Together on One Page

Compute them in this order on a case: gross debt, cash, net debt, EBITDA, interest, then the ratios, then ask what is missing from the footnotes. That sequence is the credit half of Financial Analysis Fundamentals, and it is the input to the EV bridge you will reuse in the valuation chapters.