Debt / EBITDA

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This is a ratio beloved in leveraged finance and corporate transactions and is often referred to simply as the “leverage ratio.” Unlike other covenants such as the DSCR or ICR which directly measure serviceability of debt, leverage ratios are more of a proxy for debt repayment. It is the number of years it would take for a company to repay its debt if taxes and interest did not exist. It is also an indicator of by how much a business could increase its debt without experiencing distress.

Also unlike the DSCR calculation it uses a profit rather than cashflow measure, ignoring changes in working capital (payables, receivables, inventory, etc) and any required capital expenditure. The higher the ratio, the less likely a business will be able to service its debt burden.

Variations and modifications

Gross versus net debt

Gross debt is the total debt that a business has. Net debt is simply the gross debt minus cash balances. If a company has more cash than debt, then the ratio would be a negative number. While using net debt seems reasonable on principle, as the business could immediately use the cash to repay debt, the weakness of using a net debt amount is that it is possible for the company to temporarily delay payments (and increase accounts payable) in order to artificially boost the ratio and ensure covenant compliance.

Senior versus total debt

A business might raise both senior and subordinated/mezzanine debt. Whether the debt / EBITDA covenant is measured on a senior debt or total debt basis usually depends on what enforcement and repayment rights the subordinated lender has relative to the senior lenders, and which loan documents you’re talking about.

Capital expenditure

EBITDA by definition does not incorporate any capital expenditure, even if that capital expenditure could be classified as “maintenance capex” or “sustaining capital” and is therefore necessary just to keep the business running at the same rate. For this reason, some loan documents will include a covenant calculated as

Debt / (EBITDA - maintenance capex)

This looks reasonable at face value but can have some unintended consequences. If the capex is reasonably consistent from year to year, then this ratio can represent a reasonable proxy for serviceability, whilst if it is lumpy, the ratio will fluctuate significantly, creating a challenge as to how the covenant level is set. Like other cashflow measures, it can provide an incentive for the business to accelerate or delay spending so as to manipulate the ratio result in a particular period.

See also:

Net vs gross
Senior or total debt

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Brendan WalpoleDebt / EBITDA

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