What it means
Borrowing lets a business buy assets or grow faster than it could with its own money alone. When things go well, the owners keep the extra profit after paying the lender, and returns look impressive.
The same borrowing magnifies losses when things go badly, because the lender is paid first whatever happens. There is no single level of debt that is too much, since it depends on how stable the income is.
A utility with predictable customers can carry far more debt than a start-up with lumpy sales. Analysts therefore judge leverage against earnings, cash flow and the industry.
Common warning signs include debt that is several times annual earnings, interest cover (earnings divided by interest) that is close to 1, loans that need refinancing soon, and breaches of loan conditions called covenants. Lenders may then charge higher rates or refuse new credit, which makes matters worse.
The danger is that an overleveraged business has little room to cope with surprises. A fall in sales, a rise in interest rates or a delay in customer payments can leave it unable to pay what it owes.
In the worst case, assets are sold in a hurry at poor prices, or the business enters insolvency. The usual remedies are to cut costs, sell assets, raise new equity, negotiate longer repayment terms or reduce spending on growth.
Households face the same issue when mortgage, car and card payments take too large a share of monthly income. Timing matters as much as size.
Debt that falls due in the next year is far more dangerous than the same amount repaid over ten years, because the borrower may have to refinance at the worst moment.
In practice
Real-world examples.
Example
A restaurant group borrows $8,000,000 to open ten new sites while its existing sites earn $1,500,000 a year in EBITDA. Debt is more than five times earnings, and a slow winter leaves it unable to pay its lenders on time. The owners ask the bank for a break on repayments.
Example
A property investor buys four rental flats using 90% borrowing. When interest rates rise, the monthly mortgage payments exceed rent received by $1,200 across the portfolio. She has to sell one flat to bring the debt back under control.
Example
A household carries a mortgage, a car loan and card balances that together take 60% of take-home pay. When one partner is made redundant, the family cannot meet the payments. A debt adviser helps them agree a lower payment plan.
Formula
Calculation
Net debt to EBITDA = (total debt - cash) / EBITDA
Interest cover = EBITDA / annual interest cost
A company has total debt of $12,000,000 and cash of $2,000,000, so net debt is 12,000,000 - 2,000,000 = $10,000,000. Its EBITDA (earnings before interest, tax, depreciation and amortisation) is $2,000,000. Net debt to EBITDA = 10,000,000 / 2,000,000 = 5.0 times. Annual interest is $1,000,000, so interest cover = 2,000,000 / 1,000,000 = 2.0 times.
Reading the result: it would take five years of full EBITDA to repay the net debt, and earnings could fall by only half before interest is no longer covered. Many lenders regard a multiple of 5 as high for a business with uneven income, though the acceptable level varies by industry.
A further check is the debt to equity ratio. With total debt of $12,000,000 and owners' equity of $4,000,000, the ratio is 12,000,000 / 4,000,000 = 3.0, meaning lenders have put in three dollars for every dollar of the owners' money, and the cushion for losses is thin.Case study
Seen in the real world.
Kestrel Packaging is an illustrative, fictional manufacturer that borrowed heavily to buy a competitor. Before the deal its debt was twice annual EBITDA, but after the purchase it rose to six times, mostly funded by a floating-rate loan.
Within a year, interest rates rose and a major customer cut orders by 20%. Interest cover fell towards 1.2 times, and the bank warned that the company was close to breaching its covenants.
The board sold a non-core plant for $9,000,000 and used it to repay debt, bringing the ratio down to four times. The illustrative lesson is that a good acquisition can still fail when it is financed with more debt than the earnings can carry.
Watch out
Common mistakes.
- Assuming that debt is always bad, when moderate borrowing at a sensible cost can raise returns for owners.
- Judging leverage by the size of the loan alone, rather than by earnings, cash flow and the stability of income.
- Ignoring how a rise in interest rates affects the cost of floating-rate loans.
Questions
People also ask.
How much debt is too much?
There is no universal figure, though many lenders become cautious when net debt is more than three to four times EBITDA for an ordinary business.
Can a profitable company be overleveraged?
Yes, because profits may be too small to cover interest and repayments, and profit is not the same as cash.
What is the fastest way to reduce leverage?
Selling assets and using the proceeds to repay debt, or raising new equity, are the quickest routes, though cutting costs helps over time.
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