Leverage Ratios

Analysts should adjust debt reported on the financial statements by including the firm’s obligations such as underfunded pension plans (net pension liabilities) and off-balance-sheet liabilities such as operating leases.

The most common measures of leverage used by credit analysts are the debt-to-capital ratio, the debt-to-EBITDA ratio, the FFO-to-debt ratio, and the ratio of FCF after dividends to debt.

• Debt/capital . Capital is the sum of total debt and shareholders’ equity. The debt-tocapital ratio is the percentage of the capital structure financed by debt. A lower ratio indicates less credit risk. If the financial statements list high values for intangible assetssuch as goodwill, an analyst should calculate a second debt-to-capital ratio adjusted for a write-down of these assets’ after-tax value.
• Debt/EBITDA . A higher ratio indicates higher leverage and higher credit risk. This ratio is more volatile for firms in cyclical industries or with high operating leverage because of their high variability of EBITDA.
• FFO/debt . Because this ratio divides a cash flow measure by the value of debt, a higher ratio indicates lower credit risk.
• FCF after dividends/debt . Greater values indicate a greater ability to service existing debt.