Can this company service its debt? The answer lives in the financial statements.
We extract cash flow, leverage, coverage, and trends from financial data.
We care about downside protection, not upside potential. Default risk matters more than growth prospects.
Can they pay interest and principal from operating cash flow?
What can we seize if they default? Collateral value matters.
How much debt relative to earnings? Higher leverage means higher risk.
Is performance improving or deteriorating? Direction matters as much as level.
Revolver (if drawn) and current portion of long-term debt (principal due within 12 months).
Term loans, bonds, subordinated/mezzanine debt — all debt due beyond 12 months.
Total Debt is necessary for calculating leverage ratios.
Proxy for operating cash flow and the denominator in the leverage ratio.
Annual interest burden — the denominator in the coverage ratio.
Is EBITDA growing or shrinking? Is margin stable? Direction matters.
We care less about net income — it's affected by non-cash items like depreciation and amortization that don't impact debt service capacity.
Is the business actually generating cash? This validates the quality of earnings.
How much reinvestment is required? High capex reduces cash available for debt service.
Operating cash flow - Capex = cash available for debt service and distributions.
Track issuance, repayments, refinancings — shows how the company manages its debt.
Shows how operating performance translates into debt service capacity. Every credit metric derives from steps in this waterfall.
This is the single most important framework in credit analysis.
$100M from the income statement — proxy for operating cash flow.
Capital Expenditures: ($15M) maintaining/growing the business
Change in Net Working Capital: ($5M) inventory/receivables build
Cash Taxes: ($10M) actual taxes paid, not book taxes
= Unlevered Free Cash Flow: $70M — This is cash available before considering debt obligations.
$70M — cash available before financing costs.
Cash Interest Expense: ($30M) — the annual cost of debt.
= Levered Free Cash Flow: $40M — This is what's available to pay down principal or distribute to equity.
$40M — cash available after interest.
Mandatory Principal Amortization: ($10M) — required debt paydown per credit agreement.
= Excess Cash Flow: $30M — Can be used for optional prepayments, dividends, or growth. Many credit agreements have "excess cash flow sweeps" requiring 50-75% to prepay debt.
This is the complete picture of how operating performance flows through to excess cash that can be distributed or reinvested.
Each step subtracts a different type of cash use, revealing what's truly available at each level.
Uses EBITDA from operating performance — measures debt burden relative to earnings capacity.
Uses EBITDA and interest — can we pay interest from operating cash flow?
Uses Levered FCF — can we pay everything (interest + principal)?
All three measure: Can this company handle its debt? Each looks at a different stage of the waterfall.
Total Debt / EBITDA — the most important metric in credit analysis.
Shows debt burden relative to earnings capacity. Higher ratio = higher risk.
$500M debt / $100M EBITDA = 5.0x leverage
Benchmarks: Investment grade: 1-3x • Leveraged/High-yield: 4-6x • Distressed: 6x+ • Typical covenant: Maximum 5.0x - 5.5x
EBITDA / Cash Interest Expense — measures ability to pay interest.
$100M EBITDA / $30M interest = 3.3x coverage
Higher = safer (more cushion to pay interest). Critical for floating rate borrowers — if rates rise, coverage falls.
Typical Covenant: Minimum 2.5x - 3.0x
Levered Free Cash Flow / (Interest + Principal) — most conservative metric.
$40M levered FCF / ($30M interest + $10M principal) = 1.0x DSCR
Accounts for actual cash, capex, and principal. Common in amortizing loans; less relevant for bullet structures.
Typical Covenant: Minimum 1.10x - 1.25x
Quarterly certification from the CFO that the company is in compliance with all financial covenants.
Adjusted EBITDA calculation (with permitted add-backs), Total Debt calculation, and covenant ratio tests.
Lenders monitor these quarterly. Breach = event of default unless waived. Early warning system for deteriorating credit.
Leverage Ratio: $500M / $105M = 4.76x • Maximum Permitted: 5.50x • ✓ PASS with 0.74x headroom (13%)
Non-recurring charges: Restructuring, severance, litigation settlements
Non-cash items: Stock compensation, write-downs, unrealized FX
Pro forma adjustments: Full-year EBITDA from acquisitions, cost savings/synergies
Aggressive synergy assumptions without evidence
"Run-rate" adjustments that recur every quarter
Total adjustments >20% of GAAP EBITDA
May require independent validation for large add-backs
Why it matters: Credit agreements define "Adjusted EBITDA" which can inflate by 10-25%. Quality of adjustments is critical — "garbage in, garbage out."
Most covenants use Total Debt (don't subtract cash). Always check the credit agreement definition.
Reported EBITDA ≠ Covenant EBITDA. Add-backs can be substantial (10-25%). Must follow credit agreement definition exactly.
Interest coverage uses accrual EBITDA. DSCR uses actual cash interest paid (may differ if PIK interest).
Can swing free cash flow by 20-30% quarter to quarter. Strong EBITDA doesn't always = strong cash flow.
Project covenant compliance 4 quarters forward, model M&A impact on leverage, determine dividend capacity, plan debt repayment vs. growth investment.
Underwrite new deals, monitor existing portfolio quarterly, identify early warning signs, price risk appropriately.
Assess recovery value in downside scenarios, identify covenant breach candidates, model restructuring scenarios.
Structure optimal capital stacks for LBOs, advise on covenant negotiation, rate credit risk, guide restructuring.
✓ Where to find debt in financial statements
✓ The cash flow waterfall - foundation of credit analysis
✓ How to calculate leverage, coverage, and DSCR
✓ How covenant compliance certificates work
✓ EBITDA adjustments and common errors
Now that you understand what credit analysts do, we'll explore who does this work and where: debtor-side, lender-side, investor-side, and advisory roles. How different careers use the waterfall you just learned.
After Foundations: Debt Instrument Mechanics • Capital Structure Architecture