Debt metrics and leverage ratios help us compare company's level of debt relative to some other item and give us an idea of whether a company has too much debt and whether it can handle it.
The first one we have here is net debt, which is calculated as the amount of debt less cash and cash equivalents.
This gives us a measure of a company's true indebtedness by taking into account the highly liquid assets that could be used to pay off debt.
Next we have EBITDA-based leverage, which is debt or net debt divided by EBITDA. This looks at the company's ability to service or repay date.
If we think of EBITDA a bit like cash available to pay off our date, then this figure would give us an idea of the number of years it would take to pay off our debt.
Let's say our date was 20.
And our EBITDA was four then I've got an idea that this would take us about five years to pay off. That would be pretty high.
Next we have your classic leverage ratio debt over equity or an alternative is date over debt plus equity. And this looks at the debt funding relative to owner funding in other words non-equity finance relative to equity finance.
If the level of debt was too high, we had to be worried by the leverage effect here.
Debt has a leverage effect in that it exaggerates returns to equity holders.
If returns are good, it will exaggerate them up but if returns are bad or you are a loss making company, it will exaggerate them down. It will worsen them. So if we have too much debt that exaggeration effect can be very worrying for equity holders and can make returns highly volatile.
Last we have interest cover, which is EBITDA over interest expense and this shows us a company's ability to service its interest It's ability to pay finance costs.
If the EBITDA here was 4.
And the interest expense was 1 that would be okay.
We could pay our interest 4 times over I wouldn't be getting too worried. But if I EBITDA was 2 and our interest expense was 1 we could only cover our interest expense twice. I'd be starting to worry.
And if our EBITDA was 1.1 and our interest expense was 1 I would definitely start worrying about the company's ability to service its interest. A slight dip in EBITDA would mean that we haven't made enough profit to pay our interest.
