Financial health: debt ratios, interest coverage and liquidity ratios
Measure a company's debt load, its ability to pay interest and its short-term liquidity, and stress-test them for a bad year.
What you will learn
- How to calculate net debt, debt-to-equity and net debt to EBITDA
- How to calculate interest coverage and why it matters
- How to calculate the current ratio and the quick ratio
- How to run a simple stress test and check the debt maturity profile
Explanation
A profitable company can still fail if it cannot pay its debts on time. For shareholders this is the most serious risk, because they rank last (lesson 1). Financial health analysis asks three questions: How much debt is there? Can the company pay the interest? Can it meet short-term obligations?
Debt level
- Gross debt: all interest-bearing financial debt (bank loans, bonds; many analysts also include lease liabilities and pension provisions, so state your definition).
- Net debt = gross debt − cash and cash equivalents. Negative net debt is called a net cash position.
- Debt-to-equity (D/E) = gross debt ÷ equity.
- Net debt to EBITDA = net debt ÷ EBITDA. It estimates how many years of operating earnings would be needed to repay net debt. It is widely used by lenders, and loan agreements often contain covenants: limits on this ratio which, if broken, can allow the lender to demand early repayment or better terms.
Ability to pay interest
Interest coverage = EBIT ÷ interest expense. A value of 6 means operating profit covers interest six times. The lower the value, the less room there is for a bad year or higher interest rates when debt is refinanced.
Short-term liquidity
- Current ratio = current assets ÷ current liabilities.
- Quick ratio (acid test) = (current assets − inventory) ÷ current liabilities. Inventory is removed because it may be hard to sell quickly at full value.
Rough orientation, not rules
There are no universal limits, because stable businesses (utilities, consumer staples) can carry more debt than cyclical ones (car makers, chemicals, airlines). As a very rough starting point that many analysts use: net debt to EBITDA below about 2 is usually seen as comfortable for an industrial company, and above about 4 as high; interest coverage below about 3 deserves close attention; a quick ratio well below 1 means the company depends on selling inventory or on new financing. Always compare with direct competitors and the company's history.
Maturity profile and stress test
The notes to the accounts show when debt must be repaid. A large bond due next year during weak markets is a risk even if the ratios look acceptable today. A stress test recalculates the ratios with lower earnings and higher interest to see how much buffer exists.
Worked example
Hypothetical example: Nordlicht AG (lessons 3 and 4): gross financial debt €180m, cash €40m, equity €200m, EBITDA €80m, EBIT €60m, interest expense €10m, current assets €180m, inventory €80m, current liabilities €100m. Pensions and leases are excluded from debt for simplicity.
- Net debt: €180m − €40m = €140m.
- Debt-to-equity: €180m ÷ €200m = 0.9.
- Net debt to EBITDA: €140m ÷ €80m = 1.75×.
- Interest coverage: €60m ÷ €10m = 6.0×.
- Current ratio: €180m ÷ €100m = 1.8.
- Quick ratio: (€180m − €80m) ÷ €100m = 1.0.
Stress test (hypothetical): a recession cuts EBIT by 40% to €36m. Coverage falls to €36m ÷ €10m = 3.6×. If the company also refinances at higher rates and interest rises to €15m, coverage becomes €36m ÷ €15m = 2.4×. The company is fine today but becomes noticeably more fragile in a combined bad scenario.
Common mistake
Practice activity
Hypothetical: gross debt €300m, cash €50m, EBITDA €100m, EBIT €60m, interest expense €20m, current assets €90m (of which inventory €40m), current liabilities €100m. Calculate net debt, net debt to EBITDA, interest coverage, current ratio and quick ratio. Give a short judgement.
Show solution
Net debt: €300m − €50m = €250m. Net debt to EBITDA: €250m ÷ €100m = 2.5×.
Interest coverage: €60m ÷ €20m = 3.0×.
Current ratio: €90m ÷ €100m = 0.9. Quick ratio: (€90m − €40m) ÷ €100m = 0.5.
Judgement: debt is moderate to elevated, interest coverage has little buffer, and short-term liquidity is weak. Check the maturity profile, credit lines and covenants before going further.
Limitations: including leases and pensions would raise the debt figures; ratios from one date can be distorted by seasonal effects.
Key takeaways
- Net debt = gross debt − cash; net debt to EBITDA shows the debt load relative to earnings.
- Interest coverage = EBIT ÷ interest expense; low coverage leaves little room for a bad year.
- Current and quick ratios show short-term liquidity; the quick ratio excludes inventory.
- Stress-test ratios and check when debt falls due, because ratios are only snapshots.
Next step
Next, you will use valuation multiples such as P/E, P/B and EV/EBITDA and learn their traps.
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