Credit · C5 · 9 min
Credit analysis for traders
Size a company’s debt against its earnings, check whether it can pay the interest, and spot the deals that hurt its lenders.
In the news: Results day: “net leverage rose to 4.8× as earnings fell” is the line a credit trader reads before the share price.
The essentials
- EBITDA
- Earnings before interest, tax, depreciation and amortisation: roughly the cash a company’s business produces in a year, and the income analysts measure its debt against.
- Leverage
- Debt divided by , in ‘turns’: £400m of debt on £100m of EBITDA is 4×. subtracts cash first. Strong investment-grade companies often run below about 2–3×; buyouts often start at 5× or more.
- Interest cover
- EBITDA divided by the year’s interest: £100m of EBITDA against £25m of interest is 4×. Companies with floating-rate debt see it fall as soon as interest rates rise.
- Covenants
- Promises in the debt documents. A maintenance covenant is tested every quarter, so falling earnings can breach it; an incurrence one only when the company borrows or pays out. loans have no maintenance tests.
- Event risk
- Company decisions that hurt lenders: a leveraged buyout, or borrowing to pay a dividend or buy back shares, adds debt and widens spreads. In a , lenders left out fall behind.
Credit ratios
net leverage = (debt − cash) ÷ EBITDA; interest cover = EBITDA ÷ interest
- EBITDA
- earnings before interest, tax, depreciation and amortisation, a year
- interest
- interest paid on the debt, a year
How it works
1. Debt against income
A bank deciding on a mortgage asks how big the loan is compared with your income. Credit analysts ask the same of a company. Its income measure is usually EBITDA: earnings before interest, tax, depreciation and amortisation, roughly the cash its business produces each year.
2. Leverage
Divide debt by EBITDA and you get , counted in ‘turns’: £400m of debt and £100m of EBITDA is 4×, or four years of earnings. As a rough guide, strong investment-grade companies often run below about 2–3×, while buyouts often start at 5× or more.
3. Net leverage
Cash in the bank could repay some debt today, so analysts also subtract it: = (debt − cash) ÷ EBITDA. With £400m of debt, £100m of cash and £100m of EBITDA, net leverage is 3×.
4. Interest cover
Next: can it pay the interest? = EBITDA ÷ interest. £100m of EBITDA against £25m of interest is 4×. Companies with floating-rate debt see cover fall as soon as interest rates rise.
5. Covenants
Loan agreements often include promises called . A maintenance covenant is tested every quarter, for example net leverage no higher than 4.5×. If earnings fall and the test fails, lenders can demand a fee, a higher rate or tighter terms.
6. Incurrence and covenant-lite
An incurrence covenant is tested only when the company acts, such as borrowing more or paying a dividend, so a bad quarter alone can’t breach it. Most loans to riskier companies are now : they have no maintenance tests, so lenders get a say later, when less value may be left.
7. Event risk
Some of the biggest risks for lenders are decisions, not downturns. In a leveraged buyout a buyer funds the purchase with a lot of new debt; borrowing to pay shareholders a big dividend also adds debt. Both usually widen spreads. Using asset sales or new shares to repay debt does the opposite.
8. Liability management
A struggling company may use loose loan documents to strike deals with some lenders and not others, for example letting a majority swap into new debt that is paid ahead of the rest. That is a . It buys the company time; the lenders left out fall down the queue.
Worked example
A UK company reports EBITDA of £250m. It has £1,100m of debt and £150m of cash, and pays £80m of interest a year. Its loan says net leverage must be no more than 4.0×.
- Gross leverage: 1,100 ÷ 250 = 4.4×.
- Net leverage: (1,100 − 150) ÷ 250 = 3.8×.
- Interest cover: 250 ÷ 80 ≈ 3.1×.
- Headroom: EBITDA can fall to 950 ÷ 4.0 = £237.5m, only 5% lower, before the covenant is breached.
3.8× net against a 4.0× covenant: a 5% fall in EBITDA uses up all the headroom.
Check yourself
8 quick questions on the explanation above.
Practice
New numbers every set. Misses and guesses go into your review deck.
In the interview
Answer out loud in under a minute, then compare.
Which two ratios would you check first on a new issuer?
Why is covenant-lite risky for lenders?
What’s a liability-management exercise, and who loses?
Remember
Net leverage = (debt − cash) ÷ EBITDA
Leverage says how much debt there is, cover says whether it can be serviced, and the documents say what lenders can do about it.
Sources
Definitions and maths are standard textbook material; dated facts link to the sources above. Worked numbers are illustrative.