Debt and Leverage
Debt is not automatically dangerous, but it removes flexibility. This lesson covers the two measures that matter and the situation where debt becomes fatal.
Why this matters for beginners
Most permanent losses in otherwise sound businesses involve debt that had to be repaid or refinanced at the worst possible moment.
Main explanation
Two measures cover most of the ground. Net debt to operating earnings shows how large the debt is relative to profits, and interest coverage shows how comfortably interest is paid.
The tolerable level depends on the stability of cash flow. A utility can carry debt that would endanger a cyclical manufacturer.
The maturity schedule matters as much as the amount. Debt due next year during weak conditions is far riskier than the same amount due in eight years.
Leverage magnifies outcomes. It raises returns when things go well and can eliminate equity entirely when they do not.
Example using a real company
Operating earnings of 100 against net debt of 250 is moderate for a stable business and aggressive for a cyclical one with volatile earnings.
- →Interest coverage of 8 times: comfortable.
- →Interest coverage of 1.5 times with debt maturing next year: fragile.
Common beginner mistakes
- ✕Applying one debt limit to every industry.
- ✕Looking only at the total and never at maturity dates.
- ✕Assuming refinancing is always available.
Key terms
- Net debt
- Total borrowings minus cash and equivalents.
- Interest coverage
- Operating profit divided by interest expense.
- Maturity schedule
- The timetable showing when debts must be repaid.
Key takeaways
- 01Acceptable leverage depends on cash flow stability.
- 02Maturity timing can matter more than the total.
- 03Leverage amplifies both good and bad outcomes.
Check yourself
- 01The same debt level can be safe for a utility and dangerous for a cyclical company.
- 02Only the total amount of debt matters, not when it falls due.
- 03Low interest coverage indicates limited financial flexibility.
Try the concept on a real company
Open a highly indebted company in the Analyzer and check interest coverage alongside the timing of its upcoming repayments.
Educational examples only. Not buy or sell recommendations.