G3 - Financial Analysis for Credit CH3 - Leverage

Leverage

What is financial leverage?

Use of debt to finance assets — increases potential returns and risk.

What’s the Debt-to-Equity formula (interest-bearing basis)?

Interest-bearing debt ÷ Total equity (or Tangible Net Worth).

Why use funded (interest-bearing) debt in leverage ratios?

It reflects obligations that require interest payments and principal repayment.

What does a Debt-to-Equity >1 indicate?

More debt than equity — higher leverage and risk.

Give an alternative leverage ratio to Debt-to-Equity.

Total Liabilities ÷ Equity.

What is Total Liabilities to Tangible Net Worth?

Total liabilities ÷ (Equity − Intangible assets) This is a lender-favoured metric.

Why exclude intangibles in tangible net worth?

Intangibles may have limited realisable collateral value.

What is Debt-to-EBITDA used for?

Measures debt relative to a cash-flow proxy — assesses debt burden and payback ability.

Formula for Debt-to-EBITDA?

Interest-bearing funded debt ÷ EBITDA.

Why include proposed new debt in leverage ratios?

To assess future capital structure and repayment stress.

How should related-party loans be treated?

Often considered near-equity but treated as debt unless subordinated — check agreements.

What is the impact of shareholder loan subordination?

Improves lender protection by ranking lender ahead of related-party claims.

What does a low Debt-to-EBITDA suggest?

Lower leverage and stronger capacity to support debt.

Why might tech firms tolerate higher liabilities to capital ratios?

Intangible-heavy balance sheets and growth orientation; asset collateral differs.

What is “funded debt”?

Interest-bearing loans including current and long-term portions.

What does Total Liabilities to Total Capital measure?

All liabilities ÷ (Debt + Equity) — shows proportion of liabilities in capital structure.

How can dividends affect leverage ratios?

Dividends reduce retained earnings → lower equity → higher leverage ratios.

What is an acceptable Debt-to-Equity benchmark?

Often approx 1:1 but varies by industry and lender risk appetite.

Why is maturity profile important for leverage assessment?

Concentration of near-term maturities increases rollover/refinancing risk.

How to treat operating leases in leverage metrics?

Capitalise or include off-balance-sheet obligations for a realistic leverage view (per policy).

How does off-balance-sheet financing affect leverage?

Can understate leverage; must be identified via notes/leases/guarantees.

What’s the difference between financial and business risk in leverage context?

Business risk = operational variability; financial risk = hazard from debt financing.

How does high business risk affect acceptable leverage?

High business risk usually requires lower leverage tolerated by lenders.

What is the role of collateral in leverage assessment?

Strong collateral reduces lender loss severity and may allow higher leverage.

How do interest rate rises affect leveraged firms?

Increase interest expense, reduce coverage ratios, and strain cash flows.

How do you adjust EBITDA for family-owner drawings?

Add back non-discretionary shareholder payouts if considered required for survival (adjusted EBITDA).

Why is EBITDA not actual cash flow?

It ignores working capital changes, capex and tax/interest cash flows.

What’s a lender’s concern with long tenors and floating rates?

Repricing risk and potential future increases in debt service.

How to interpret very low leverage on early-stage firms?

Could signal lack of access to debt or deliberate equity-financed growth.

What is debt layering?

Using different debt tranches (senior, mezzanine) with different seniority and cost.

How does the lack of covenant structures change leverage risk?

Reduce lender control, increasing borrower risk-taking and potential default exposure.

What’s the implication of rising leverage trend in horizontal analysis?

Increasing financial risk — investigate cause (dividends, acquisitions, losses).

How to treat cash for net debt calculations?

Net debt = interest-bearing debt − cash & short-term investments (if appropriate).

Why might lenders exclude restricted cash from available cash?

It’s not available for general debt service.

How can refinancing risk be modelled?

Project cashflows to maturity and stress test refinancing rates/availability.

What’s a common covenant tied to leverage?

Maximum Debt-to-EBITDA or minimum Tangible Net Worth.

How to evaluate the quality of equity?

Check retained earnings history, capital contributions, and related-party loan levels.

Why examine changes in intangible assets when assessing leverage?

Large intangibles increase reported equity but provide weak collateral.

What effect do large acquisitions have on leverage?

Can spike funded debt and goodwill, increasing leverage and reducing tangible coverage.

One-sentence leverage rule for lenders?

Ensure leverage and coverage metrics leave a sufficient cushion under stress and match asset cashflows.