An indebted company is not necessarily fragile, and a debt-free company is not necessarily solid. What counts is its ability to honour its commitments over time. Three simple tools give you an idea from the balance sheet and the income statement.
Net debt and leverage
Gross debt adds up all of the company's borrowings. But some companies also hold a lot of cash, which could repay part of the debt. So we calculate net debt: financial debt minus available cash. Negative net debt means the company holds more cash than debt. To know whether the debt is heavy, we compare it with what the company earns. The net debt / EBITDA ratio shows in how many years of gross operating earnings (before depreciation and amortisation) it could repay its net debt. The lower it is, the more room for manoeuvre. Thresholds vary widely from one sector to another: a utility, with very stable revenues, can carry more debt than a technology company with cyclical revenues.
Interest coverage and strength
The interest coverage ratio compares operating profit with the interest to be paid each year. It answers a concrete question: do profits cover the cost of the debt, and by what margin? Also look at the maturity schedule: debt falling due in 12 months weighs far more than the same debt due in 10 years. The type of rate matters too, because floating-rate debt is more exposed to rising rates. Finally, the trend tells you more than an isolated figure: leverage that rises quarter after quarter is a signal not to ignore.
Below 1.5, the company depends on the slightest hiccup to run into difficulty.
Worked illustration (fictional)
Company A has €500M of debt, €200M of cash, EBITDA of €150M and operating profit of €100M against €20M of interest. Its net debt is €300M, or 2 times EBITDA, and its interest coverage is 5. Company B, with the same net debt but EBITDA of €50M and operating profit of €25M against €20M of interest, shows leverage of 6 and coverage of 1.25: a modest drop in activity would jeopardise its interest payments. Illustrative example.
Debt amplifies cycles
In good times, debt amplifies profitability. In hard times, interest is still due while profit falls. A highly indebted company in a cyclical sector combines both weaknesses.
Key takeaway
- ✓Net debt (debt minus cash) gives a truer picture than gross debt.
- ✓Leverage and interest coverage are read against the sector and the trend, never in absolute terms.
- ✓The maturity schedule and the type of rate matter as much as the amount of debt.