Ironvale Steel, a fictional steelmaker, adds $250 million to its cash pile between its FY3 peak and FY5 downturn. Cash rises from $151.25 million to $401.25 million. Yet earnings before interest and taxes (EBIT) cover its annual interest bill only 1.47 times in FY5, down from 6.25 times at the peak.
More cash, less breathing room. To judge the debt burden, you need to connect three things: the amount owed, the earnings supporting it, and the repayment dates.
What counts as debt
Financial leverage means using borrowed money alongside owners' capital. Solvency is the ability to meet obligations over time, beyond the short-term bill-paying question that liquidity ratios address.
Here, interest-bearing debt includes short- and long-term borrowing that carries interest. Trade payables and other operating bills stay outside this total. Net debt subtracts available cash and cash equivalents from it.
Harbor Coffee, our fictional coffee business, supplies the steadier comparison. Both companies' cash is unrestricted, and we subtract it all. Unrestricted does not mean spare: each business still needs money to operate.
Use the EBITDA definition from the previous lesson, with no extra addbacks. Neither company models material leases.
Harbor's three debt checks
Use Harbor's reported FY3 accounts: balances at year-end, earnings and interest expense for the full year. Dollar amounts below are USD millions; ratios are calculated and rounded.
Harbor owes $30 short-term plus $270 long-term: $300 total. Debt-to-equity divides this borrowing by shareholders' equity at the same date: $300 ÷ $544.4 = 0.55 times.
Subtract Harbor's cash: $300 − $105.4 = $194.6 of net debt. Divide by its $260 EBITDA to get 0.75 times.
Coverage uses gross interest expense from the income statement, before subtracting any interest income. Cash interest paid is a different measure.
| Check | Numerator | Denominator | Result |
|---|---|---|---|
| Debt/equity | $300 | $544.4 | 0.55× |
| Net debt/EBITDA | $194.6 | $260 | 0.75× |
| EBIT/interest | $220 | $20 | 11× |
Harbor owes about $55 per $100 of recorded owners' capital. Net borrowing is about $75 per $100 of annual EBITDA. It earns $11 before interest and tax for each $1 of interest expense.
More debt against similar earnings leaves less room for error; higher coverage gives a larger cushion. At 1×, EBIT only matches interest; below it, EBIT falls short. That signals pressure, not a default date.
An earnings multiple is not a repayment clock. Harbor's 0.75× does not mean it can clear its net debt in nine months. Taxes, capital spending and working capital compete for cash, as the cash-flow statement shows.
What a downturn changes
In Ironvale's five-year history, FY3 is the peak and FY5 the later downturn. Its reported inputs below pair year-end debt and cash with full-year EBITDA; net debt and multiples are calculated. Dollar amounts are USD millions.
| Input or check | FY3 peak | FY5 downturn |
|---|---|---|
| Debt | $1,150 | $1,300 |
| Cash | $151.25 | $401.25 |
| Net debt | $998.75 | $898.75 |
| EBITDA | $670 | $330 |
| Net debt/EBITDA | 1.49× | 2.72× |
Cash rises $250 million while debt rises $150 million, so net debt falls $100 million. But EBITDA more than halves. Less net debt, a heavier burden relative to earnings.
The interest cushion narrows too: the EBIT bar shrinks while the interest bill grows.
A peak-year denominator can make borrowing look deceptively light in cyclical businesses.
Interest comes out before owners' profit. Harbor's $220 million EBIT less $20 million interest leaves $200 million before tax.
Suppose EBIT rises or falls 10%—$22 million—while interest stays fixed. Pretax profit rises to $222 million or falls to $178 million: an 11% move either way. Each $1 change hits a smaller earnings base, so the percentage move grows. This is earnings sensitivity, not a share-price forecast.
When the principal comes due
The cash flow lesson put principal repayments in financing. A debt's maturity is its repayment date. Covering interest does not repay the loan.
Harbor's accounts give you a first-year amount, but no detailed schedule for what follows.
Harbor's $105.4 million of cash exceeds the first $30 million bucket. The $270 million beyond it could come due in a lump or in smaller installments; the accounts supplied here do not say.
Refinancing replaces old borrowing with new borrowing. A debt covenant is a loan condition, such as a limit on a debt ratio. Its contract may define EBITDA differently. Harbor's interest rates, whether they can change, and its room under covenant limits are unknown.
Cash already held can meet a bill now; cash from operations arrives over time. Even a profitable business can face a funding gap if a large maturity arrives first. Refinancing needs a lender before it becomes a source of cash.
Harbor's 11× coverage shows a large earnings cushion. It leaves a debt-note question: “When does the $270 million come due, and what loan conditions apply?” Missing dates leave the funding question open; they do not establish distress.
When a ratio stops helping
Compare similar businesses across several years, including weak ones. A steady business and a steelmaker can have the same multiple with very different earnings risk. There is no safe number that fits every business.
Debt-to-equity can also rise because losses or buybacks shrink book equity, even without new borrowing. A rising ratio tells you to inspect both sides of the fraction.
Banks need a different toolkit because borrowing and lending are their business. These operating-company checks do not carry over mechanically.
Even when debt looks manageable, stock-based compensation can change how much of the business each share represents.
In short
- Debt ratios need consistent definitions and matching periods.
- Leverage sizes the debt; coverage measures the interest cushion; maturities put repayment on a calendar.
- Less net debt can still mean a heavier burden if earnings fall faster.
- EBITDA is an earnings subtotal, not cash available to repay lenders.
- Strong interest coverage cannot tell you whether a large maturity can be funded.