Leverage and Coverage Ratios: What Each One Can Withstand

Leverage ratios ask how much has been borrowed against something a business holds. Coverage ratios ask whether a year of earnings can service what has been borrowed. The split is arithmetic, not style. Leverage divides one balance sheet figure by another, so a date moves it. Coverage divides one annual figure by another, so no date can. Anjani Stationers is 6.7 per cent geared and covers its interest 11.9 times.

The panel opens on what Anjani Stationers Private Limited published, and a figure that lives only inside a script cannot be read by anyone who does not run it, so here is that opening setting as ordinary text. Borrowings Rs 10,20,000, cash Rs 5,00,000, equity Rs 1,42,00,000, total assets Rs 1,80,00,000, earnings before interest and tax (EBIT) Rs 41,50,000, depreciation and amortisation Rs 12,00,000, finance cost Rs 3,50,000 and an annual lease payment of Rs 2,00,000. From those eight the panel builds three amounts once and shares them out: net debt of Rs 5,20,000, earnings before interest, tax, depreciation and amortisation (EBITDA) of Rs 53,50,000 and a fixed charge of Rs 5,50,000. The four leverage measures then read 7.2 per cent debt to equity, 6.7 per cent gearing, 5.7 per cent debt to total assets and 0.10 times net debt to EBITDA, and the three coverage measures read 11.9 times interest cover, 15.3 times EBITDA to interest and 7.5 times fixed-charge coverage. Two identities hold wherever their denominators are above nil, and the panel checks both on screen rather than asserting them: gearing is debt to equity divided by one plus debt to equity, and the gap between the two interest measures is the depreciation charge over the finance cost, here Rs 12,00,000 over Rs 3,50,000, or 3.4286 times.

Two settings pull the two sides apart in a way no single reading can. A drawing taken late in the year adds borrowings to a set of accounts without adding to the charge for the year. Put another Rs 39,80,000 in that way and every leverage measure climbs while all three coverage measures sit exactly where they were. Restoring the borrowings and letting the finance cost run to four times its size instead reverses it: the leverage side does not stir and the coverage side thins out. In each of those the panel prints a warning. A test written on one of the two measures alone would have reported no change in a year when something changed.

Here is the machinery underneath that. A balance sheet figure is a photograph: it records what stood there on 31 March and on no other day. A figure from the statement of profit and loss is a total of everything that happened between one 1 April and the next. A photograph divided by a photograph describes an instant; a total divided by a total describes a year. Every difference in this guide falls out of that one distinction.

The pieces are already in hand. The seasonal facility that Anjani Stationers Private Limited draws through the season and clears before 31 March is established, and so is the argument about what a measurement date does to a borrowing figure. Both are set out where the borrowings themselves are treated. Debt to equity has already been built and pulled apart definition by definition. The margin ladder from revenue down to profit after tax is settled, so EBIT of Rs 41,50,000 and EBITDA of Rs 53,50,000 are figures available for use rather than derivation. The coverage measures are the second group, built out of the year rather than out of the balance sheet, and one test sorts any ratio met for the rest of a working life into one group or the other.

What is the difference between a leverage ratio and a coverage ratio?

A lender asks a household exactly these two questions and asks them in exactly this order, so start with the household. First: how much is already owed, against the flat already paid for and the savings held? The first is a question about the size of a pile. Second: can a monthly salary carry the instalment on top of everything else that must be paid? The second is a question about whether a stream can cover a claim on it. Both questions are reasonable, neither answers the other, and a lender who asks only one of them has decided something without knowing it.

A leverage ratioA ratio that measures the size of what a business has borrowed against the size of something it holds, such as its equity or its total assets. It describes proportion, not affordability. measures the size of what has been borrowed against the size of something the business holds, and a coverage ratioA ratio that measures how many times a year of earnings covers a charge that must be paid out of those earnings, such as interest or a lease payment. measures how many times a year of earnings covers a charge that has to be met out of those earnings. The first group counts what is owed against a stock of something. Debt to equity, gearing, debt to total assets and net debt to EBITDA all sit here. The second group counts a year against a year. Interest cover, EBITDA to interest and the fixed-charge measures sit here. One thing changes between the groups: the numerator stops being an amount owed and becomes an amount earned, and the denominator stops being an amount held and becomes an amount that had to be paid. Nothing about that swap is cosmetic.

How is each leverage ratio built on the published figures?

Anjani Stationers Private Limited closed the year with borrowings of Rs 10,20,000, being a term loan of Rs 4,20,000 and a lease liability of Rs 6,00,000, against equity of Rs 1,42,00,000, total assets of Rs 1,80,00,000 and cash of Rs 5,00,000. Four measures come out of those figures.

Gearing on Anjani Stationers reads 6.7 per cent, debt to total assets reads 5.7 per cent, and net debt to EBITDA reads 0.10 times, all from the same Rs 10,20,000 of borrowings sitting on top of three different denominators. Take them in turn. Debt to equity puts borrowings over equity: Rs 10,20,000 over Rs 1,42,00,000, or 7.2 per cent. Debt to equity has already been built and pulled apart in its own right. Gearing puts borrowings over borrowings plus equity: Rs 10,20,000 over Rs 1,52,20,000, or 6.7 per cent. Gearing answers a slightly different question, namely what share of the total funding came from lenders. Debt to total assets puts borrowings over everything the business holds: Rs 10,20,000 over Rs 1,80,00,000, or 5.7 per cent. Net debt to EBITDA is the odd one, and worth pausing on. Net debt is borrowings less cash, Rs 10,20,000 less Rs 5,00,000, or Rs 5,20,000, and net debt divided by EBITDA of Rs 53,50,000 gives 0.10 times.

Look at what net debt to EBITDA has just done. Its numerator came off the balance sheet and its denominator came off the statement of profit and loss. Net debt to EBITDA is therefore a hybrid ratioA ratio whose numerator and denominator come from different kinds of statement, typically a balance sheet amount divided by an amount for the year. It carries the properties of both., and a hybrid inherits the awkwardness of both parents. Net debt to EBITDA is usually described as a leverage measure and it behaves like one. The only part of it a change of calendar can move is the numerator, since the denominator is fixed for the year whatever date is chosen. So the date problem lives in the top half of that fraction only, and knowing that is more useful than memorising which list the ratio belongs to.

How is each coverage ratio built, and what does the EBITDA version assume?

Now cross to the other group, where every input is a total for the twelve months rather than a photograph of one day. Anjani Stationers Private Limited earned EBIT of Rs 41,50,000 and EBITDA of Rs 53,50,000 across the year, and was charged a finance cost of Rs 3,50,000 across the same year.

Interest coverEBIT divided by the finance cost for the same year. It counts how many times over the year's operating profit covered the year's interest charge. on Anjani Stationers is Rs 41,50,000 over Rs 3,50,000, or 11.9 times, and EBITDA to interest on the same year is Rs 53,50,000 over Rs 3,50,000, or 15.3 times. Both count the same charge. The two measures differ only in how much of the year's earnings they are willing to count as available to meet it, and the whole of that difference is the Rs 12,00,000 of depreciation and amortisation that separates EBIT from EBITDA. The second measure therefore carries an assumption the first does not. Adding depreciation back says that the money represented by that charge did not have to leave the business this year. Depreciation is not a payment, so that much is true. The add-back quietly also says, if nobody watches, that the money never has to leave, and that is false. The binding machines and the cutting line wear out. Over one year the add-back is a fair description of cash. Over the life of an asset it is a description of a business that never replaces anything.

Which inputs are stocks, and which are flows?

Here is the idea worth carrying away. Every input sorts into one of two kinds before anything is divided. A stock measureA quantity measured at a single instant, such as a balance on 31 March. It has a date attached and no duration. is a quantity that exists at an instant and has a date attached: borrowings, equity, total assets, cash. A flow measureA quantity accumulated over a period, such as a year of revenue or a year of finance cost. It has a duration attached and no single date. is a quantity accumulated over a period and has a duration attached: revenue, EBIT, EBITDA, the finance cost, the lease payments made.

Watch this on a household before the accounts. A household borrows Rs 80,000 against gold in November for a wedding, repays it steadily and clears the last rupee in the second week of March. Photograph the loan papers on 31 March and the household has no gold loan. The photograph is true, and it is a poor description of the year. Now look at the interest the household actually paid between November and March. The interest paid knows about every week the loan was outstanding, and no choice of photograph date can shrink it. One fact, seen two ways, and only one of the two ways survives a change of viewing angle.

A ratio built from two stocks describes one instant and inherits every accident of the date it was measured on. A ratio built from two flows describes a whole period and cannot be moved by choosing a date at all. Anjani Stationers Private Limited demonstrates both at once. The cash credit facility was drawn through the season and cleared before the year end, so borrowings stood at Rs 10,20,000 on 31 March and averaged Rs 37,00,000 across the twelve months. So gearing reads 6.7 per cent on the reporting date and 20.7 per cent on average borrowings. Interest cover reads 11.9 times on either basis. There is no other basis to read it on: EBIT of Rs 41,50,000 and a finance cost of Rs 3,50,000 are both the whole year already. The measurement-date argument itself is set out in full where the borrowing profile was first established.

What happens to every one of these ratios when the measurement date moves?

Do not take the claim on trust. Test it, on all seven measures at once, and count the results. The test is simple: substitute average borrowings of Rs 37,00,000 for the reporting-date figure of Rs 10,20,000, hold every other published input exactly where it is, and recompute. The substitution is not a full mid-year balance sheet. The substitution isolates the one input a change of date moves most, and that is what makes it a fair test.

Every one of the four leverage measures moves, each of them multiplying by more than three, and not one of the three coverage measures moves at all. The table below sets the seven out on both bases, row by row. Two of its rows repay a second look. Gearing lands at 20.7 per cent, the figure already published on average borrowings, and that gap is why gearing and debt to equity must never be treated as the same measure. Net debt to EBITDA moves because its numerator moved while its denominator sat still. Four moved, three did not, and the sorting is exactly the sorting of the previous section.

One more piece of arithmetic settles the matter, and it is the kind of check worth building into a reading habit. Anjani Stationers Private Limited was charged Rs 3,50,000 of finance cost for the year. Set against the reporting-date borrowings of Rs 10,20,000, the implied rate is 34.3 per cent. No ordinary lender charged 34.3 per cent. Set against average borrowings of Rs 37,00,000, the implied rate is 9.5 per cent, an unremarkable figure. The finance cost line is itself evidence about the borrowings the reporting date does not show. A reader holding only the published statements can detect the seasonal facility without being told about it. The finance cost divided by the closing borrowings, on any set of accounts, is the whole of the check. Where the answer is absurd, the closing figure is not describing the year.

Because a finding trapped inside a panel is invisible to anyone who cannot run it, here are the readings that matter, written out. At the default 31 March setting the panel reproduces the published position exactly: borrowings Rs 10,20,000, gearing 6.7 per cent, interest cover 11.9 times, and a count of nothing moved on either side. Walk back to July, the peak of the season, and borrowings read Rs 62,20,000, debt to equity reads 43.8 per cent against 7.2 on the reporting date, gearing reads 30.5 per cent against 6.7, and the count reads four of four leverage measures moved and none of three coverage measures moved. Try every one of the twelve dates and the coverage count never leaves zero. No date turns EBIT of Rs 41,50,000 and a finance cost of Rs 3,50,000 into different numbers. Press the average button and the leverage readings land on 26.1, 20.7, 20.6 per cent and 0.60 times, the same four figures the table above computed by hand.

Why is a leverage measure almost always read beside a coverage measure?

Because each one is blind exactly where the other sees. Take the household again. A household that owes very little but has just lost the salary that was paying the instalment looks excellent on the size of the pile and cannot make the next payment. A neighbouring household that is paying every instalment comfortably out of a large monthly income, but has borrowed an amount it could never repay if the income stopped, looks excellent on affordability this month and is carrying something the next year has to deal with. Neither picture is wrong. Each is half.

Leverage without coverage states how much is owed and says nothing about whether this year could pay for it. Coverage without leverage states that this year was comfortable and says nothing about how much has to be repaid or refinanced when it falls due. On Anjani Stationers Private Limited the pair works in a specific way. Gearing of 6.7 per cent on 31 March describes a business funded almost entirely by its owners on that date, and it says nothing whatever about the Rs 3,50,000 that had to be found for lenders during the year. Interest cover of 11.9 times describes a year in which operating profit was many times the charge, and it says nothing about the Rs 10,20,000 of term loan and lease liability that still has to be paid down, nor about the facility that will be drawn again next season. Read alone, either one gives half a picture that looks complete. Half a picture that looks complete is more dangerous than a picture that obviously has a hole in it.

What does fixed-charge coverage add to interest cover?

Interest cover counts one charge. A business rarely has only one. Think about a small tailoring unit near a bus depot: the loan instalment is real, and so is the rent on the shed, and the owner who counts only the instalment when working out whether the month closes has left out the payment most likely to arrive first. Fixed-charge coverageA coverage measure that widens the denominator beyond interest to include other charges a business has committed to meet, most commonly lease payments. Definitions vary, so the components must be listed. widens the denominator to take in the other amounts a business has committed to pay before anything is discretionary.

Adding the Rs 2,00,000 annual lease payment to the Rs 3,50,000 finance cost gives a charge of Rs 5,50,000, and Anjani Stationers Private Limited covers that Rs 5,50,000 with its Rs 41,50,000 of EBIT 7.5 times against the 11.9 times it covered interest alone. Nothing about the business changed between those two readings. The denominator got wider, so the number got smaller, and the reader learns something the narrower measure was silent about. Two cautions belong with this measure and both are practical. First, definitions of it vary more than those of any other measure in this guide: some readers add the whole lease payment, some add only its interest portion, some add scheduled repayments of principal, some add preference dividends. A fixed-charge coverage figure quoted without its component list cannot be compared to another one. Second, fixed-charge coverage is still a flow over a flow and still immune to the measurement date. Immunity to the date is why it sits in the coverage group despite the change of denominator.

Where does each of these inputs sit in a filing?

Seven ratios came out of six numbers. Here is where each of those six is found in a set of published accounts.

Borrowings are split between current and non-current liabilities on the face of the balance sheet, and the components behind both figures sit in the borrowings note. The finance cost is its own line in the statement of profit and loss. EBIT is not printed anywhere: it is built by taking profit before tax and adding the finance cost back to it, so for Anjani Stationers Private Limited it is Rs 38,00,000 plus Rs 3,50,000. EBITDA is not printed either, and it is built by adding the depreciation and amortisation charge to EBIT, giving Rs 41,50,000 plus Rs 12,00,000. Lease payments are in the leases note, and cash and cash equivalents is its own balance sheet line; both are picked up again in the cash flow statement. Two of the six numbers are never printed in any filing and have to be assembled by the reader. Knowing which two before the search begins saves a long hunt through the notes.

Who reads these two measures together, and what do they do with them?

Three people open the same set of accounts in the same week, and none of them is reading these seven numbers for the same reason.

A lender reads the coverage measure to price the risk of the coming year and the leverage measure to size what has to be refinanced, an analyst reads the finance cost against the closing borrowings to find out whether the reporting date is describing the year, and Vaidehi Rao reads both because she is the one who has to answer for either. Watch each of them work. The lender at Anjani Stationers Private Limited is being asked to renew a seasonal facility. Interest cover of 11.9 times says the year that just closed carried its charge comfortably, and that is a real fact about a real year. On 31 March that facility stood at nil, so gearing of 6.7 per cent says almost nothing useful about the facility being renewed. The lender therefore does what a reporting date cannot do for it and asks for the peak drawing and the average drawing. Facility documents ask for figures the published accounts never show, for exactly that reason.

The analyst has no such privilege and has to work from what is printed. The move available is the one set out above: the finance cost divided by the closing borrowings, then a judgement about whether the answer is believable. On Anjani Stationers the 34.3 per cent that comes back is a signal rather than a rate, and it changes how every leverage figure here should be read. And Vaidehi Rao, as finance controller, sits between the two. When a bank asks her for gearing she has to know which date the question is about. Both 6.7 per cent and 20.7 per cent are true, both are computed from the same published figures, and the two answer different questions. Handing over one figure without its basis is how a conversation goes wrong later.

Anjani Stationers Private Limited, Chitra Binding Works and Vaidehi Rao are invented.
Educational material. Not advice on any investment, tax, budget or market position.