If the spread is the price of a credit, the coverage and leverage ratios are the fundamentals that justify it. There are only a handful that matter, and they answer two distinct questions: how much debt is there relative to the earnings/assets that back it (leverage)? and how comfortably can the company service that debt from its cash generation (coverage)? A credit can fail either test independently. High leverage with strong coverage (a stable utility) is a different animal from low leverage with weak coverage (a volatile cyclical at the bottom of its cycle).
The leverage ladder.
- Debt/EBITDA: the market's lingua franca. Gross debt over EBITDA; "turns of leverage." 2× is conservative, 4× is meaningful, 6×+ is leveraged-buyout territory. Its virtue is comparability; its vice is that EBITDA is not cash (M2.04's whole lesson) and can be inflated (M2.06's).
- Net Debt/EBITDA: gross debt minus cash and liquid investments. Appropriate when the cash is genuinely available to repay debt. Beware two traps: cash that is trapped in subsidiaries or overseas (not freely available to the bondholder), and the "cash" that isn't real (Satyam, Cox & Kings; the QoE cash-yield test is a credit test).
- Debt/Capital and Debt/(Debt+Equity): balance-sheet gearing, useful where EBITDA is volatile or negative but book equity means something (less useful for asset-light firms whose book equity understates value).
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What are the coverage and cash-flow ratios?
The coverage ladder (each rung more conservative than the last):
- EBITDA/Interest: the headline. How many times over does operating cash-before-everything cover the interest bill? Above ~4× is comfortable for most industrials; below ~2× is stressed.
- EBIT/Interest: subtracts depreciation, a proxy for the maintenance capital the business really consumes. Always lower than EBITDA/interest; the gap is a rough capital-intensity tell.
- (EBITDA − capex)/Interest: the honest one for capital-heavy businesses. A telecom or a steel mill with 4× EBITDA/interest can have barely 1.5× coverage once the capex it cannot skip is subtracted. This ratio is where fair-weather coverage meets the maintenance bill.
The cash-flow ladder, the rating agencies' favourite, because it is hardest to fake. These use funds from operations, not EBITDA:
- FFO (funds from operations) ≈ EBITDA − net interest paid − cash taxes. It is operating cash flow before working-capital swings, a cleaner run-rate of internal cash generation than reported CFO (which working capital can flatter or savage in any one year).
- FFO/Debt: the agencies' single most-cited metric. ~45%+ is strong (low-A and up), ~20–30% is mid-investment-grade, ~12% or below is firmly speculative. Because it is cash over debt, it cross-checks the EBITDA-based leverage number: a company with 3× Debt/EBITDA but 12% FFO/Debt is telling you EBITDA is not converting to cash.
- RCF/Debt: retained cash flow, meaning FFO minus dividends. It measures deleveraging capacity after shareholder returns, the cash actually left to pay down debt. A company whose FFO/Debt is healthy but whose RCF/Debt is thin is prioritising shareholders over creditors, which the creditor prices.
- FCF/Debt, the ultimate test: FFO minus capex (and dividends). Positive and growing FCF de-levers a company automatically; persistently negative FCF means debt only grows, and the credit lives or dies by continued market access.
How do analysts adjust debt and EBITDA?
The adjustments that separate professionals from spreadsheet-fillers. Reported debt is rarely the debt a credit analyst uses.
- Leases. Under Ind AS 116 / IFRS 16, most leases are already capitalised as a right-of-use asset and a lease liability, and lease payments split into depreciation and interest, so reported EBITDA is "post-capitalisation." Rating agencies typically include the lease liability in debt. Ignore it and you understate leverage badly: a retailer with ₹1,200 crore of borrowings, ₹800 crore of lease liabilities, and ₹500 crore of EBITDA looks like 2.4× on borrowings alone but is 4.0× including leases. That is 1.6 turns hidden in the notes (worked in practice problem 7). Under legacy US GAAP operating-lease treatment you must capitalise them yourself (a rent multiple, or the disclosed liability).
- Pensions and other debt-like items. Underfunded defined-benefit pensions, guarantees, factored receivables with recourse, and hybrid securities all get debt (or partial-debt) treatment depending on their features. The principle: if it behaves like a fixed obligation senior to equity, treat it as debt.
- Standalone vs consolidated, and structural subordination. For a holding-company creditor, the debt that matters is the debt ahead of them at the operating subsidiaries, because subsidiary creditors are paid from subsidiary assets before anything flows up to the holdco. The gap between consolidated and standalone debt is where this "structural subordination" hides (IL&FS again; priority of claims formalises it).
Through-the-cycle, not point-in-time. A cyclical company's leverage at the top of its cycle is a lie of omission. The credit analyst normalises to mid-cycle EBITDA, or to the trough EBITDA of the last downturn, and asks whether the capital structure survives the bad year, not just enjoys the good one. This is the single discipline that most separates a credit read from an equity read: equity prices the expansion; credit underwrites the recession.