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How do you calculate net debt to EBITDA for a credit analysis?

One balance sheet, four leverage ratios, and the IFRS 16 mismatch that makes a 3.86x credit look like 3.21x.

Julian R. Sterling · from Credit Analysis

Net debt to EBITDA is debt less cash, divided by EBITDA, with both sides measured on the same basis. For one illustrative borrower the answer runs from 3.69x on a covenant-style definition that ignores leases to 4.50x once lease liabilities, the pension deficit and only the cash that can actually repay debt are counted. The lender's number is the second, and the 0.81 turn gap comes from three choices: the lease basis, the debt-like claims and which cash is netted.

Worked in full in Credit Analysis by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →

The borrower

A mid-sized manufacturer reporting under IFRS 16, so its reported EBITDA of 70.0 excludes the 9.0 of rent it pays, and its balance sheet carries the matching lease liability. All figures are illustrative, in millions.

Balance sheet items and earnings at the test date

Item	Amount
Senior term loan	250.0
Revolving credit facility, drawn	30.0
Lease liabilities (IFRS 16)	45.0
Unfunded pension deficit	20.0
Shareholder loan, subordinated, interest rolled up	60.0
Cash on the balance sheet	55.0
of which held in a subsidiary that cannot pay it up	15.0
Minimum operating cash the business needs	10.0
Reported EBITDA (after IFRS 16)	70.0
Rent, deducted in pre-IFRS 16 EBITDA	9.0

The calculation, four ways

One borrower, four leverage ratios

Basis	Net debt	EBITDA	Leverage
Covenant style: no leases, rent in EBITDA, all cash netted	225.0	61.0	3.69x
IFRS 16 consistent: leases in debt, rent out of EBITDA	270.0	70.0	3.86x
Lender adjusted: plus pension, accessible cash only	315.0	70.0	4.50x
Including the shareholder loan	375.0	70.0	5.36x

The first two lines differ only in how leases are treated, and they differ because the leases are carried at 5.0 times the rent while the business as a whole is levered at under four times. Bringing a liability levered more heavily than the company onto the balance sheet raises the ratio. Lease leverage on its own is 0.64x.

What goes into net debt, item by item

Starting from the IFRS 16 consistent ratio, each adjustment a credit analyst makes moves the number by its amount divided by EBITDA.

From 3.86x to 5.36x

Adjustment	Amount	Net debt after	Leverage	Turns added
IFRS 16 consistent starting point		270.0	3.86x
Add the pension deficit	20.0	290.0	4.14x	0.29
Remove trapped cash	15.0	305.0	4.36x	0.21
Remove minimum operating cash	10.0	315.0	4.50x	0.14
Add the shareholder loan	60.0	375.0	5.36x	0.86

• Pension deficit: a fixed claim on future cash that competes with the lenders for it, and in some jurisdictions the pension trustees or regulator can press for it to be funded first. Most analysts add it, sometimes net of the tax relief on contributions.
• Trapped cash: cash in a subsidiary that exchange controls, minority shareholders or local covenants stop from reaching the borrower does not repay the borrower's debt.
• Minimum operating cash: the business cannot run with an empty till. Cash needed for payroll and working capital swings is not surplus.
• Shareholder loan: subordinated, paying no cash interest and maturing after the senior debt, it behaves like equity for a senior lender, so the 4.50x line is the lender's number. A rating agency may count it unless those features hold, and a mezzanine or second lien lender should look at 5.36x.

Together the cash adjustments remove 45.5 per cent of the cash the covenant nets, which is why a cash-netting cap in the credit agreement is worth negotiating hard.

The common mistake: mixing bases

IFRS 16 created a trap that still catches models. Leases must be in net debt if EBITDA excludes rent, and out of it if EBITDA is after rent. Mix them and the ratio is wrong in a predictable direction:

Consistent and inconsistent lease treatment

Net debt	EBITDA	Leverage	Verdict
Without leases (225.0)	Pre-IFRS 16 (61.0)	3.69x	Consistent
With leases (270.0)	Post-IFRS 16 (70.0)	3.86x	Consistent
With leases (270.0)	Pre-IFRS 16 (61.0)	4.43x	Double counts the leases
Without leases (225.0)	Post-IFRS 16 (70.0)	3.21x	Flatters by 0.64 turns

The flattering version is the one that turns up in borrower presentations: headline EBITDA from the reported accounts, net debt from the facilities schedule. It understates leverage by exactly the lease leverage, 0.64 turns, and makes a 3.86x credit look like a 3.21x one. Many credit agreements avoid the question by freezing accounting at the pre-IFRS 16 standard, which is why the covenant line here uses 61.0 of EBITDA and leaves leases out. Whether operating leases should count at all is argued in do uncapitalised leases count as debt.

What is a good net debt to EBITDA?

There is no single level. Illustratively, investment grade industrial borrowers often sit below three times, while sponsor-backed leveraged loans are commonly underwritten at four to six times. The useful comparison is not with a market norm but between the ratio and what the borrower's cash can repay: a credit at 4.50x that converts most of its EBITDA to cash is stronger than one at 3.69x that does not. The number of turns a given EBITDA can carry is worked in how to calculate debt capacity from EBITDA.

Takeaway

• Match the bases: leases in debt with post-IFRS 16 EBITDA, or out with pre-IFRS 16 EBITDA.
• Count debt-like claims and net only the cash that can repay debt: 4.50x here, not the 3.69x covenant figure.
• State each adjustment in turns so the credit committee sees which one decides the answer.

The leverage measured four ways, and what goes missing from net debt, is laid out for one borrower in the free workbook for this case.

Questions readers ask

Should leases be included in net debt?

Only if EBITDA excludes the rent. Under IFRS 16 reported EBITDA is before lease costs, so lease liabilities belong in net debt: in the example 270.0 over 70.0 gives 3.86x. If the agreement freezes accounting before IFRS 16, use EBITDA after rent and leave leases out: 225.0 over 61.0 gives 3.69x. Mixing the two gives 3.21x, a ratio that describes no real company.

Which cash should be deducted in net debt?

Only cash that can actually repay the borrower's debt. In the worked case 15.0 of the 55.0 sits in a subsidiary that cannot pay it up and 10.0 is the minimum the business needs to operate, so only 30.0 is netted. Removing the other 25.0 adds 0.36 of a turn, taking leverage from 4.14x to 4.50x.

Is a shareholder loan debt in net debt to EBITDA?

For a senior lender usually not, if it is subordinated, pays no cash interest and matures after the senior debt, because it behaves like equity. Rating agencies and junior lenders may count it. In the example including the 60.0 shareholder loan adds 0.86 of a turn, from 4.50x to 5.36x.

Also on this site

• How do you calculate a company's debt capacity from EBITDA?Take the lower of the leverage limit and the cover limit, both on the lender's EBITDA: 120,955,000 here, 955,000 above the debt the borrower already has.
• Do uncapitalised leases count as debt in a leverage covenant?No. Putting 4,150,000 of operating leases in the covenant and charging interest on them moves year-one accretion 4.1351 points. Both legs are wrong.
• What is an EBITDA add-back bridge actually worth in leverage turns?Six add-backs move leverage 1.6866 turns; the 4.25x covenant leaves 0.0336 of a turn. The bridge is 50.3 times the headroom it is tested against.
• What probability of default does a loan margin break even at?Margin over loss given default: 400 bp against an LGD of 26.52 per cent breaks even at a 15.08 per cent PD, and at 8.91 per cent if the exit multiple is 3.0x.
• How does operating leverage amplify a lender's downside case?Twice: an 8 per cent revenue fall at 2.2x operating leverage cuts EBITDA 17.6 per cent and cash for debt service 26.99 per cent, taking cover from 1.25x to 0.91x.
• How do you calculate expected loss on a loan: PD x LGD x EAD?EL = PD x LGD x EAD: 2.5 per cent x 52.2 per cent x €125.0m gives €1.63m. Using drawn exposure and undiscounted LGD reports €1.02m, 37.1 per cent too low.

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