Leverage Ratio
A leverage ratio measures how much debt a company carries against its capacity to service it — net debt divided by EBITDA for an operating company; capital divided by total assets for a bank, the regulator's simplest test. It is the number that sizes a buy-out's debt, sets the covenants, and tells a buyer how much of a target's enterprise value the lenders already own.
- Also known as
- Leverage, Net debt to EBITDA, Debt multiple
- Used at
- every leveraged transaction and loan agreement; bank supervision (the Basel III leverage ratio requires Tier 1 capital of at least 3% of total exposure); credit analysis of any borrower
- Binding
- as a covenant in loan agreements (a maximum, tested quarterly) and as a regulatory minimum for banks
- Typical levels
- 4–6× net debt to EBITDA in 2024–2025 buy-outs, up to 7× at the 2021 peak; 2–3× for investment-grade corporates; a payments company with a stable float can carry more than a lender whose EBITDA depends on credit losses
- Typical arithmetic
- net debt = borrowings less cash (less, in a fintech, the client money and regulatory capital that are not the company's to spend); EBITDA = the covenant definition, with add-backs capped
- Parties
- borrowers, lenders and rating agencies; sponsors sizing the debt; buyers reading the target's ratio to see what the equity is worth
How a leverage ratio works in practice
A sponsor buying a company with €20m of EBITDA asks lenders how much they will lend: at 4.5×, €90m; the rest of the €200m price is equity. The ratio is the lender's judgement of the cash flows' stability — a subscription-software company at 6× is safer than a lender at 3× — and it moves with the credit market: the same company that borrowed 6.5× in 2021 refinanced at 4.5× in 2023 and needed €40m of new equity to do it. Over the loan's life the ratio is expected to fall as debt is repaid and EBITDA grows; the covenant steps down to match, and a company whose ratio does not fall is one whose plan has failed.
For a buyer of a leveraged company the ratio says what the equity is worth. Enterprise value €200m with €90m of net debt is €110m of equity; the same enterprise value with €140m of net debt is €60m of equity that will double or vanish on a 20% move in the business. The multiple of EBITDA the buyer pays is the same; the ratio decides who receives it.
Banks are measured differently: the leverage ratio is capital over total assets regardless of risk, a backstop to the risk-weighted ratios, and at 3% it means a bank can hold €33 of assets for every €1 of capital — a leverage no operating company would be lent.
Example
A payments company is bought at €200m with €90m of senior debt: 4.5× its €20m of EBITDA, net debt €84m after €6m of cash (the €38m of safeguarded client money and €6m of own funds do not count). Year one: EBITDA €23m, debt repaid to €80m, cash €8m — net debt €72m, 3.1×. Year three: EBITDA €30m, net debt €50m, 1.7×, and the sponsor recapitalises: it borrows back up to 4.0× (€120m), pays itself a €70m dividend, and the company's ratio is 4.0× again on a larger business. The lenders agreed because the cash flows had proved themselves; the sponsor had returned its entire equity before selling. The company's leverage ratio was the same at the start and after the recapitalisation, and the equity had made 2× in between.
Common mistakes
- Counting a fintech's client money or regulatory capital as cash in net debt. - Sizing leverage on adjusted EBITDA the lender's definition will not accept. - Assuming the ratio a company carried in 2021 is a ratio it can refinance at. - Reading a target's enterprise value multiple without its leverage, and mistaking the equity's risk. - Comparing a bank's leverage ratio with a company's; they measure different things on different bases.