Debt and leverage: the red flags in the notes

Why the headline number is the least interesting one

Open a balance sheet and you will find borrowings split into current and non-current. Subtract cash and you have net debt. Divide that by earnings before interest, tax, depreciation and amortisation and you have the ratio most people quote.

That figure is a starting point and almost nothing else. It tells you the size of the obligation. It tells you nothing about when it comes due, what it costs, what currency it is in, what happens if a ratio slips, what assets are pledged against it, or whether other obligations that behave exactly like debt have been left out of the total.

All of that is in the notes to the accounts. Under international reporting standards, entities are required to disclose information about liquidity risk, including a maturity analysis of financial liabilities, along with their exposures to interest rate and currency riskSource^source. The disclosure exists because the standard setters concluded, correctly, that the amount alone does not describe the risk.

Corporate borrowing is watched at the system level for the same reason. International financial institutions track corporate leverage because heavy borrowing amplifies stress when conditions tighten, converting a slowdown into a wave of refinancing problemsSource^source. What is true across an economy is true inside one company. Debt does not create risk by existing. It creates risk by removing flexibility at the exact moment flexibility becomes valuable.

What leverage actually does

Borrowing does one thing mechanically. It fixes some of your costs while leaving your revenues variable.

Suppose a business has assets of 1,000 producing an operating return of 8 per cent, or 80. Financed entirely by equity, owners earn 8 per cent. Now finance 500 of it with debt costing 5 per cent. Interest is 25, leaving 55 for owners on 500 of equity, a return of 11 per cent. Leverage improved the outcome.

Run the same structure through a bad year in which the operating return falls to 3 per cent, or 30. The all-equity owner earns 3 per cent. The leveraged owner pays 25 of interest and keeps 5 on 500 of equity, a return of 1 per cent. The operating result fell by roughly 60 per cent. The leveraged equity return fell by around 90 per cent.

Push it one step further. If the operating return falls to 2 per cent, or 20, the leveraged business cannot cover its interest from operations at all, and now the question is not returns but survival.

That asymmetry is the entire subject. Leverage does not make good businesses better or bad businesses worse. It makes outcomes more extreme and it converts a bad year into an existential one at a threshold that the leverage ratio alone does not reveal.

The four questions the balance sheet cannot answer

When does it come due

A company with 1,000 of debt maturing evenly over ten years and a company with 1,000 maturing entirely in fourteen months are not comparable, whatever the ratio says. Refinancing risk is the most common way that a manageable debt load becomes a crisis, because refinancing depends on credit markets being open on a particular date, which is outside the company's control.

Look for the maturity table in the notes. Ask three things. What proportion falls due within two years? Is there a single year with a disproportionate concentration? And are there undrawn committed facilities large enough to cover a near-term maturity if markets close?

What does it cost, and does that cost move

Fixed rate debt has a known cost. Floating rate debt reprices with benchmark rates, which are set and revised by monetary authorities over time and feed through to borrowing costsSource^source. A company with mostly floating rate debt has a cost base that can rise without anything happening in its business.

The notes usually disclose the split, and often a sensitivity analysis showing the effect of a given move in rates. Read that sensitivity against operating profit, not against revenue, because it is operating profit the interest has to come out of. Also check whether the company hedges, for how long, and what happens when the hedges expire, because a hedge is a deferral, not a cure.

What currency is it in

If a company earns in one currency and borrows in another, a currency move changes the size of the debt in the currency of its earnings without any change in the business. This is a well-worn source of trouble, and it is entirely visible in the notes if you look for the currency breakdown of borrowings alongside the geographic breakdown of revenue.

A natural hedge, borrowing in the currency you earn in, removes most of this. Its absence is worth a specific note in your research.

Who is ahead of you, and what is pledged

Not all debt is equal. Secured debt has claims on specific assets. Debt at an operating subsidiary sits closer to the cash flows than debt at the holding company, so holding company creditors and equity holders are further back in the queue than the group total suggests. If most of the borrowing sits at subsidiaries while the equity you are researching sits at the parent, structural subordination is a real feature of your position, not a technicality.

Covenants, the tripwires

A covenant is a promise attached to a loan. Typically it requires the borrower to keep some ratio inside a limit, such as net debt to earnings below a threshold, or interest cover above one.

The mechanism matters more than the wording. Covenants convert a gradual deterioration into a sudden event. A company whose earnings drift downwards has a problem. A company whose earnings drift downwards through a covenant threshold has a different problem, because the lender may then demand repayment, reprice the facility, or impose conditions. The debt that was due in five years can become due immediately.

When researching, look for four things.

• Whether covenants exist at all, and what they measure.
• How much headroom there is between the current ratio and the limit.
• Whether the definitions are the company's own adjusted measures rather than statutory ones, since a covenant tested on adjusted earnings has different slack than the headline figures suggest.
• Whether covenants have been renegotiated or waived recently, which is a signal in itself.

Headroom is the number that matters, not the ratio. A company at 2.8 times against a 3.0 times covenant is in a materially tighter position than one at 3.5 times with no covenant at all, and the ranking of the two on a leverage screen is exactly backwards.

Debt that is not labelled debt

Several obligations behave like borrowing, consume cash on a fixed schedule, and rank ahead of shareholders, without appearing in the line called borrowings.

Leases

Under current standards, lessees generally recognise a right of use asset and a corresponding lease liability, which brought a large class of previously off balance sheet commitments onto the balance sheetSource^source. Two consequences follow. Comparisons with older financial years are distorted, and industries built on leased property or leased equipment now carry visible liabilities that materially change their leverage. Check whether a leverage ratio you are quoting includes lease liabilities, because both conventions are in circulation.

Supply chain finance and receivables factoring

Arrangements where a bank pays suppliers early, or buys receivables from the company, can move an obligation out of the debt line and into trade payables. Economically the company has borrowed. The signals are payables stretching well beyond normal terms for the industry, or a working capital improvement with no operational explanation. Disclosure practice varies, so read the accounting policy note as well as the numbers.

Pension and end of service obligations

Defined benefit schemes and long service obligations are promises to pay employees in the future. Where a scheme is in deficit, the company owes money on a schedule. It is not called debt and it behaves like it.

Guarantees and joint arrangements

A guarantee of a joint venture's borrowing is a contingent liability that becomes a real one if the venture struggles. These sit in the contingencies note, which is one of the least read and most informative sections of any annual report.

Hybrid and perpetual instruments

Instruments with no maturity date, or with equity accounting treatment but debt-like coupons, can be classified as equity while imposing regular payments. Read what the instrument requires the company to pay and when, rather than the label on it.

Worked example, same ratio, different odds

Two hypothetical companies, both with net debt of 600 and annual earnings before interest, tax, depreciation and amortisation of 200. Both report leverage of 3.0 times. Any screen ranks them identically.

**Company X.** All debt is fixed rate at 5 per cent, maturing evenly between four and nine years from now. Interest cost is 30, giving interest cover of about 6.7 times. There are no financial covenants on the main facility. The debt sits at the parent. Revenue and borrowing are in the same currency. There is an undrawn committed facility of 150.

**Company Y.** All debt is floating rate, currently costing 5 per cent, and the whole amount matures in eighteen months. Interest cost is also 30 today, so interest cover is also 6.7 times. There is a covenant requiring leverage below 3.5 times. A quarter of the borrowing is in a foreign currency. There is no undrawn facility.

Now apply an ordinary bad year in which earnings fall 25 per cent, from 200 to 150, and benchmark rates rise by two points.

Company X still has interest of 30 and cover of 5.0 times. Leverage rises to 4.0 times. Nothing is triggered, nothing is due, and management has years to fix it.

Company Y now pays roughly 42 in interest, giving cover of about 3.6 times. Leverage rises to 4.0 times as well, which breaches the 3.5 times covenant. The entire debt is refinanceable within eighteen months, into a market that has just repriced, with a covenant breach on record and a currency exposure that may have moved against it.

Identical leverage. Entirely different situations. Every distinguishing fact came from the notes.

Coverage beats leverage in a downturn

Leverage ratios compare a stock (debt) with a flow (earnings). Coverage ratios compare two flows, and in a stress scenario they are the more direct question, because companies fail when they cannot make payments, not when a ratio looks high.

Two worth computing yourself:

1. **Interest cover.** Operating profit divided by interest expense. Then recompute it with earnings 25 per cent lower and interest a couple of points higher, which is the scenario that actually arrives.
2. **Cash coverage of near-term obligations.** Cash from operations, less the capital spending genuinely needed to keep operating, compared against debt maturing in the next two years plus interest. If the answer is negative, the company must refinance, and refinancing is a market condition rather than a management decision.

A red flag checklist

Run these in order against the notes rather than the summary tables.

1. **A maturity wall.** A large share of borrowing due within two years without committed facilities to cover it.
2. **Covenant headroom under roughly twenty per cent**, particularly where the covenant is tested on company-defined earnings.
3. **Mostly floating rate debt with no hedging**, or hedges expiring inside the maturity horizon.
4. **Currency mismatch** between where the company earns and where it borrows.
5. **Payables stretching** faster than revenue, or a working capital gain with no operating explanation.
6. **Leverage rising while earnings fall**, which is the direction that closes options rather than opens them.
7. **Lease liabilities excluded** from the leverage figure being quoted.
8. **Guarantees to associates or joint ventures** disclosed in the contingencies note.
9. **Refinancing at materially worse terms** than the debt being replaced, which is the credit market's opinion of the company stated in numbers.
10. **Repeated covenant amendments or waivers**, which indicate the relationship with lenders is already being managed rather than simply maintained.

None of these is a verdict. Each is a question that should have an answer in the documents, and an unanswerable one is itself worth recording.

Sector edge cases

For **banks and insurers**, leverage is the business model, not a choice, and these ratios do not apply. Capital adequacy, funding mix, liquidity coverage and asset quality carry the analysis instead.

For **regulated utilities and infrastructure**, high leverage can be entirely rational because revenues are contracted or regulated and therefore far more predictable. Judge the debt against the stability of the cash flow it is secured on, not against a general benchmark.

For **real estate**, valuation-linked covenants add a second failure path. A fall in appraised property values can breach a loan to value covenant even when rent collection is unchanged.

For **Islamic financing structures**, the legal form differs from conventional borrowing but the analytical questions are the same. Ask what payments are fixed, on what schedule, secured on what assets, with what consequences if a ratio is missed.

What this analysis cannot tell you

Debt analysis identifies fragility. It does not identify failure, and it says nothing about value.

It cannot tell you whether the borrowed money was well spent. Debt used to build an asset that earns above its cost is wealth creating; the same debt used to buy back shares at a high price is not, and both look identical on the balance sheet.

It cannot price the equity. A heavily indebted company can be an excellent investment at a low enough price and a poor one at a high price, and none of these ratios addresses price.

It cannot predict lender behaviour. Covenant breaches are frequently waived, particularly where lenders judge that the alternative is worse. Waivers usually cost something in fees, rates or restrictions.

And it cannot substitute for reading the actual documents. Every worthwhile fact in this article lives in the notes, not in the summary figures, which is the practical reason that leverage is the area where careful readers most reliably find things that screens miss.