How Much Debt Is Too Much? Net Debt/EBITDA and Interest Coverage
Updated: 5 hours ago
Debt is too much when a company could not survive a bad year without cutting its dividend, issuing shares or breaking its loan terms. In numbers, the Five Criteria set three tests: net debt of no more than 2.0 times EBITDA, operating profit that covers interest at least 5 times, and free cash flow that covers the dividend. A company that passes all three can usually ride out a recession on its own resources.
Debt is not good or bad in itself. It amplifies results in both directions. Used modestly by a strong business, it can lift returns. Used heavily, it turns an ordinary downturn into a permanent loss for shareholders. This guide shows you how to measure it and where the danger lines are.
Where this fits: this is the hub for Criterion 4, sound balance sheet, of the Five Criteria. The numbers come from all three statements, covered in how to read financial statements.
Why Debt Matters So Much to Stock Investors
Shareholders are paid last. Suppliers, employees, tax authorities and lenders all get their money first. If the business struggles, debt holders can force a sale, a restructuring or a share issue at a terrible price. Shareholders take the loss.
A company with no debt can survive a recession, a price war or a management mistake. There are no fixed payments that must be met regardless of results. A heavily indebted company has no such patience. Interest is due whether revenue is up or down, and loans must be repaid or refinanced on a set date, whatever the credit markets look like that month.
Buffett made the point memorably in his 2001 letter to Berkshire Hathaway shareholders: only when the tide goes out do you discover who has been swimming naked. Debt is what leaves companies exposed when the tide goes out. Howard Marks has written for decades that leverage magnifies outcomes, good and bad, without improving the underlying investment.
Criterion 4 exists because of one simple fact, explained in survival first: the math of staying in the game: a 50% loss needs a 100% gain to recover. Overleveraged companies are one of the most common sources of those large, permanent losses.
What Counts as Debt?
Start with the balance sheet and add up every form of borrowing:
Short-term debt: bank loans, commercial paper and the current portion of long-term debt, all due within 12 months.
Long-term debt: bonds, term loans and similar borrowing due after 12 months.
Lease liabilities: under IFRS 16, and for most leases under US GAAP, future lease payments sit on the balance sheet. For retailers, airlines and restaurants these can be large. Treat them as debt.
Debt-like items: unfunded pension deficits and, in some cases, large provisions. Check the notes.
Net debt = total debt - cash and cash equivalents. Cash can repay debt tomorrow, so it is netted off. A company with more cash than debt has net cash, the strongest position of all.
Be careful with cash held abroad or trapped in subsidiaries, and cash the business needs day to day to operate. Not all of it is truly available to repay debt.
Test 1: Net Debt to EBITDA (House Maximum 2.0x)
Net debt / EBITDA measures how many years of operating earnings, before depreciation, it would take to repay the debt. It is the most widely used leverage ratio, and the one lenders put in their loan agreements.
EBITDA is operating income plus depreciation and amortisation, taken from the income statement or the cash flow statement. It is a rough proxy for the cash the business produces before investment, interest and tax.
Net debt / EBITDA | General reading | Five Criteria view |
Net cash (below 0) | Very strong | Pass |
0 to 1.0x | Conservative | Pass |
1.0x to 2.0x | Moderate | Pass |
2.0x to 3.0x | Elevated; common in stable industries | Fail by default |
Above 3.0x | High; depends on very stable cash flow | Fail |
Why 2.0x rather than the 3.0x many lenders accept? Because EBITDA falls in a recession, and the ratio rises with it. A company at 2.0x in a good year can be at 3.0x after a 30% fall in EBITDA. One at 3.0x can quickly reach 4.5x, which is where covenant breaches, credit downgrades and forced share issues begin.
Test 2: Interest Coverage (House Minimum 5x)
Interest coverage = operating income (EBIT) / interest expense.
It tells you how many times over the business can pay its interest from operating profit. Where net debt/EBITDA measures the size of the debt, interest coverage measures the cost of carrying it.
Interest coverage | Reading |
Above 10x | Very comfortable |
5x to 10x | Comfortable: passes the Five Criteria |
3x to 5x | Adequate, but little room for a bad year |
1.5x to 3x | Stretched |
Below 1.5x | Danger: profit barely covers interest |
Use EBIT, not EBITDA, for this test. Depreciation reflects real assets wearing out that must eventually be replaced, so it is not truly available to pay interest over the long run.
Watch what happens when rates rise. A company with a lot of variable-rate debt, or large amounts to refinance soon, can see coverage fall sharply without any change in the business. For example, $2 billion of variable-rate debt costs an extra $40 million a year if rates rise by two percentage points.
Test 3: Free Cash Flow Covers the Dividend
The third test comes from the cash flow statement. Free cash flow (operating cash flow minus capex) should be larger than the dividends paid, on average over several years.
If it is not, the company is funding its dividend with borrowing or asset sales. That can last a while, but not forever, and the dividend cut usually comes at the worst moment. See what is free cash flow for how to calculate it properly.
Worked Example: Company A vs Company D in a Recession
Company A is the hypothetical garden-tool maker used throughout our financial statements series. Company D is a hypothetical competitor of the same size that took on debt to fund acquisitions and buybacks. Figures are in millions of dollars.
In a normal year
Measure | Company A | Company D |
EBITDA | 200 | 200 |
Operating income (EBIT) | 150 | 150 |
Net debt | 200 | 700 |
Interest expense | 20 | 50 |
Net debt / EBITDA | 1.0x | 3.5x |
Interest coverage | 7.5x | 3.0x |
In a good year, Company D looks fine. Its earnings per share may even be higher, because it bought back shares with borrowed money.
After a 30% fall in EBITDA
Now a recession cuts EBITDA by 30%, to 140. Depreciation stays at 50, so operating income falls to 90.
Measure | Company A | Company D |
EBITDA | 140 | 140 |
Operating income (EBIT) | 90 | 90 |
Net debt / EBITDA | 1.4x | 5.0x |
Interest coverage | 4.5x | 1.8x |
Outcome | Bruised, but keeps investing and paying a dividend | Likely covenant pressure; may need to issue shares or sell assets |
Company A's coverage dips just below our 5x default, which shows why that default is a buffer rather than a luxury: even after the hit, it still earns its interest four and a half times over. It can keep investing, maybe even buy a struggling competitor cheaply. Company D may have to cut its dividend, sell assets or issue new shares at a depressed price, permanently diluting its owners. Same business, same recession, completely different result for shareholders. That is what Criterion 4 is designed to catch. Read more on how that happens in stock dilution explained.
Supporting Checks Beyond the Three Ratios
Debt maturity profile
The notes to the accounts list when each piece of debt falls due. A company that passes the ratios but must refinance most of its debt in the next 12 to 24 months carries risk the ratios do not show. In a credit crunch, refinancing can become very expensive or temporarily impossible.
Fixed vs variable rate
Fixed-rate debt has a predictable cost. Variable-rate debt gets more expensive when rates rise. Check the mix in the notes.
Covenants
Bank loans often include covenants, such as a maximum net debt/EBITDA. Breaching one can let lenders demand repayment or impose stricter terms. If the company is close to its covenant limit, treat that as a warning.
Credit rating
Ratings of BBB- (S&P and Fitch) or Baa3 (Moody's) and above are investment grade. Below that, the market is already pricing in a higher chance of default. A downgrade below investment grade can raise borrowing costs sharply.
The trend
Is net debt/EBITDA falling over five years, or rising? Healthy businesses usually reduce leverage over time from their own free cash flow. Rising leverage without a clear, high-return reason means the company is consuming more cash than it produces.
Red Flags in a Company's Debt
Leverage rising year after year without a clear investment programme behind it.
Borrowing to pay the dividend or to buy back shares.
Large debt maturities in the next two years with limited cash.
Heavy variable-rate debt in a rising-rate environment.
Frequent "adjusted EBITDA" figures that add back recurring costs, making leverage look lower.
A credit rating below investment grade, or a recent downgrade.
For more warning signs, see red flags in a business.
Sector Exceptions
Some businesses are built to carry more debt. Regulated utilities and many REITs have predictable cash flows and routinely run higher leverage. Banks and insurers use leverage as part of their business model and need completely different measures, such as capital ratios.
These exceptions are worth knowing, but they do not change the default. For the vast majority of companies you will research, the Five Criteria thresholds apply. If you are analysing a sector outside them, make sure you understand it well enough to judge its specific risks.
How We Use This in the Five Criteria
Criterion 4 asks one question: can it survive a bad year without diluting or defaulting? A company passes if it meets all three defaults:
Net debt / EBITDA of 2.0x or less.
Interest coverage (EBIT / interest) of 5x or more.
Free cash flow that covers the dividend.
Then we run the recession check above: cut EBITDA by 30% and see whether the company would still be safe. Finally, we check maturities and the trend.
Criterion 4 also ties into how much you own. Even a company that passes can surprise you, which is why the Five Criteria pair a sound balance sheet with sensible position sizing. Your portfolio's survival depends on both.
Common Mistakes When Judging Debt
Looking at total debt without netting cash, or netting cash that is not really available.
Forgetting leases and pension deficits.
Using "adjusted" EBITDA that strips out real, recurring costs.
Judging leverage in a boom year. Test it against a recession-level EBITDA.
Ignoring maturities. A manageable debt load can still be dangerous if it all comes due at once.
Assuming debt is always bad. A little cheap, long-dated debt in a highly cash-generative business can be perfectly sensible.
Frequently Asked Questions
What is a good net debt to EBITDA ratio? The Five Criteria default is 2.0x or less. Below 1.0x is conservative, and net cash is best of all. Above 3.0x is high for most businesses outside regulated sectors.
Is debt to equity a good measure of leverage? It is less reliable than net debt/EBITDA, because book equity can be distorted by buybacks, write-downs and old acquisitions. Some strong companies even have negative equity.
Why use EBIT for interest coverage but EBITDA for leverage? EBITDA is the convention for leverage, and it is what lenders use. For interest coverage, EBIT is more conservative, because equipment must eventually be replaced, so depreciation is a real cost.
Should I avoid every company with debt? No. Modest, long-dated, fixed-rate debt in a business with strong free cash flow is fine. What you want to avoid is debt that could force the company to dilute you or default in a bad year.
Your Next Step
Run the three Criterion 4 tests on one company you own, then repeat them with EBITDA cut by 30%. Then read survival first to see why this matters so much for your long-term returns, and score the full company with the Five Criteria Checklist.
About the author: Cameron Hayes is a senior investor relations and finance professional who has worked in IR at Nasdaq Copenhagen-listed companies including Nilfisk and Maersk Drilling. He holds an MSc from Copenhagen Business School and a BCom from the University of Ottawa, and founded Gingernomics to teach individual investors the Five Criteria framework. More about Gingernomics.
The content on Gingernomics is for educational and informational purposes only and does not constitute financial advice. Always do your own research and consult a licensed financial advisor before making any investment decisions. Past performance is not indicative of future results.
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