Case 100Credit analysis and ratingsCore

Two borrowers each have revenue of Rs 1,000 crore, EBITDA of Rs 150 crore and debt of Rs 450 crore. One has half its costs fixed, the other a tenth. Revenue falls 20%. What happens to each, and what does operating leverage mean for the lender versus the shareholder?

Oaktree Capital ManagementLos Angeles · 2024

The situation

Durvesh Chemicals and Brisvara Staffing look identical on paper: revenue of Rs 1,000 crore, EBITDA of Rs 150 crore, and Rs 450 crore of debt at 9%, so leverage is 3.0x and EBITDA covers interest 3.7 times.

Their costs are built differently. Durvesh runs plants: half of its Rs 850 crore of costs, Rs 425.0 crore, are fixed, and the rest move with volume. Brisvara places contract workers and pays them only when a client does: only a tenth of its costs, Rs 85.0 crore, are fixed. In a downturn, both see revenue fall 20%.

Your task

What happens to EBITDA, leverage and interest cover for each, and how does operating leverage affect lenders and shareholders differently?

Quick check

After a 20% revenue fall, roughly what is Durvesh's EBITDA?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Durvesh's EBITDA falls to Rs 35 crore and leverage jumps to 12.9x; Brisvara's falls to Rs 103 crore and leverage only to 4.4x. Fixed costs turn a 20% revenue dip into a 77% EBITDA fall, and Durvesh can no longer cover its interest. Operating leverage amplifies both directions, but the shareholder keeps the upside while the lender, paid a fixed coupon, only feels the downside. Lenders therefore want less debt on high fixed-cost businesses.

Step 1Why do two identical-looking borrowers react so differently?

Because EBITDA is what is left after costs, and only variable costs fall when revenue falls. Durvesh loses Rs 200 crore of revenue but saves only Rs 85 crore of cost, so EBITDA falls Rs 115 crore; Brisvara saves Rs 153 crore and EBITDA falls only Rs 47 crore. A restaurant owner who owns the kitchen and pays fixed salaries keeps paying them on a quiet night; a caterer who hires staff per event simply hires fewer. The first is operating leverageThe degree to which profit swings more than revenue because some costs do not change with volume. at work.

Rs croreDurvesh, beforeDurvesh, afterBrisvara, beforeBrisvara, after
Revenue1,0008001,000800
Variable costs(425)(340)(765)(612)
Fixed costs(425)(425)(85)(85)
EBITDA15035150103
Debt / EBITDA3.0x12.9x3.0x4.4x
EBITDA / interest of 40.53.7x0.86x3.7x2.54x
The same 20% revenue fall takes Durvesh's EBITDA from Rs 150 crore to Rs 35 crore and its leverage to 12.9x, while Brisvara's EBITDA falls only to Rs 103 crore and leverage to 4.4x.
Same revenue dip, different cost structures, Rs croreDurvesh Chemicals: 50% of costs fixed150EBITDA before35After -20% revenueDebt / EBITDA: 3.0x to 12.9xEBITDA / interest: 3.7x to 0.86xBrisvara Staffing: 10% of costs fixed150EBITDA before103After -20% revenueDebt / EBITDA: 3.0x to 4.4xEBITDA / interest: 3.7x to 2.54x
After a 20% fall in revenue, Durvesh's EBITDA drops from Rs 150 crore to Rs 35 crore and its leverage from 3.0x to 12.9x, while Brisvara's drops to Rs 103 crore and 4.4x, so fixed costs turn a revenue dip into a leverage spike.
Step 2Why does operating leverage hurt the lender more than the shareholder?

Run the upturn too. With revenue up 20%, Durvesh's EBITDA rises 77% to Rs 265 crore and Brisvara's 31%. The shareholder owns that upside in full; the lender still receives its 9% and nothing more, while standing directly in front of the downside. So operating leverage is a gamble a shareholder might welcome and a lender cannot be paid for. At Rs 35 crore of EBITDA, Durvesh covers its Rs 40.5 crore of interest only 0.86 times: the lender's claim is at risk after one bad year.

EBITDA swing for revenue plus or minus 20%: who feels which sideDurvesh, revenue +20%+77%Durvesh, revenue -20%-77%Brisvara, revenue +20%+31%Brisvara, revenue -20%-31%upside: goes to shareholdersdownside: lenders feel itThe lender's return is capped at the coupon, so it gains nothing from the right side.
A 20% swing in revenue moves Durvesh's EBITDA by plus 77% or minus 77% and Brisvara's by plus 31% or minus 31%, and because a lender's return is capped at the coupon, it bears the downside of that swing without sharing the upside.

Close with what a lender does about it. Lend less against high fixed-cost businesses, and size the loan on EBITDA after a stress, not on today's figure. If a lender wants Durvesh to stay under 4.5x in a 20% revenue fall, debt can be no more than about Rs 157 crore, 1.05x today's EBITDA; Brisvara could carry its Rs 450 crore comfortably. The limitation: fixed costs are rarely perfectly fixed, and a management team will cut some of them in a downturn, but not quickly enough to save a loan sized on good-year EBITDA.

Where candidates lose it

The common error is cutting EBITDA by the same 20% as revenue, to Rs 120 crore, for both companies. That assumes every cost is variable and hides the whole point of the question.

The second is answering that operating leverage is bad for everyone. It amplifies both ways; the asymmetry comes from the lender's capped payoff, and saying that is what the interviewer is listening for.

What the interviewer asks next

  • At what revenue fall does Durvesh's EBITDA stop covering interest?
  • How would you structure covenants differently for Durvesh and Brisvara?
  • Which of the two would a private equity sponsor rather buy with leverage, and why?

Asked at Oaktree Capital Management, Credit, Los Angeles, 2024 (Wall Street Oasis): How does operating leverage affect debt vs. equity holders

Company names and figures are illustrative.