Senior Leverage Ratio

How to Calculate Senior Leverage Ratio

Senior debt refers to borrowed money that a company must repay first if it were to default on its debt obligations and thus become insolvent (i.e. bankruptcy).

The senior leverage ratio is a practical metric for evaluating a company’s debt burden and risk of default, especially from the perspective of lenders.

By comparing senior debt to EBITDA, the senior leverage ratio—a modification to the standard total leverage ratio—offers insights into whether a company is over-leveraged relative to its earnings power.

Compared to the total leverage ratio, the senior leverage ratio is a more conservative measure of risk, but more useful for understanding its outstanding obligations to senior lenders, most often banks.

The most common forms of senior debt are secured senior bank loans, which are collateralized (i.e. lien), and senior bonds, which can be secured or unsecured.

The senior leverage ratio is a critical measure of financial risk, where a high senior debt ratio implied that the company’s total senior debt is significant relative to its earnings, which could put a heavy burden on the company’s cash flow (and increase the risk of default if earnings decline).

In the context of lending, the senior leverage ratio not only provides lenders with insights into a company’s current financial health and risk profile, but the pecking order with regard to existing debt obligations.

In practice, lenders rely upon the senior leverage ratio to assess a company’s ability to repay its debt and may set maximum limits as a conditional parameter stated in the lending agreement (i.e. loan covenant).

Most companies raise capital from senior lenders because the debt is “cheaper” and priced at a lower interest rate. The trade-off is that the lender has the rightful claim to claim the pledged collateral in the event of default, where the borrower misses a interest payment or is unable to repay the original loan principal in-full.

The step-by-step process to calculate the senior leverage ratio are as follows:

• Step 1 ➝ Determine Sum of Senior Debt on Balance Sheet
• Step 2 ➝ Calculate EBITDA (EBIT + D&A)
• Step 3 ➝ Divide Total Senior Debt by EBITDA

Senior Leverage vs. Total Leverage Ratio: What is the Difference?

The senior leverage ratio compares a company’s senior debt to a measure of its earnings or cash flow.

Thus, the senior leverage ratio provides a more conservative measure of leverage than the total leverage ratio, which includes all of a company’s debt (senior and subordinated).

In contrast, the total leverage ratio divides a company’s gross debt by its EBITDA (or EBIT).

The debt component comprises senior and subordinated debt, so the numerator is more inclusive of a company’s borrowings.

The total leverage ratio will be higher than the senior leverage ratio, assuming the borrower has subordinated debt on its balance sheet.

Subordinated debt is repaid after senior debt in the event of a bankruptcy, i.e. absolute priority rule (APR) and lower claim in capital structure.

By focusing solely on senior debt, the senior leverage ratio measures the debt burden and risk of default on financing arrangements with senior lenders, like banks.

The senior leverage ratio intentionally excludes subordinated debt given the fact that the obligations are lower priority and carries less risk for the company.

Senior lenders most often require a lien on the company’s pledged collateral and are more conservative—compared to non-bank lenders—as part of the lending transaction.

In practice, both the senior and total leverage ratio are used by lenders to analyze the credit risk of prospective borrowers, among other risk ratios.

Why Does the Senior Debt Ratio Matter in Lending?

Senior lenders in particular use the senior leverage ratio to set loan covenants, as their debt has the highest priority claim on the company’s assets, where a “ceiling” is set on the amount of senior debt that can be raised.

If a borrower breaches the loan covenant stated on the lending agreement, the lender has the right to penalize the borrower (e.g. require a full repayment of the original amount, including fees as compensation for the foregone interest).

In recent times, covenants have become less strict, namely because of the emergence of non-traditional lenders.

Senior lenders also tend to become more lenient amid periods of strong economic conditions (and more conservative during economic downturns).

Ultimately, whether a senior leverage ratio is “good” boils down to the context of the company, the circumstances surrounding the borrowing (i.e. intended use of the debt), and the prevailing economic environment, including the near-term and long-term outlook.

But still, most senior lenders implement covenants into their lending agreements, which the borrower is legally required to abide by.

Why? Senior lenders tend to be more conservative and prioritize protecting themselves against the risk of incurring a capital loss (“downside risk”), even if that means earning a lower yield on the financing arrangement.

Senior Leverage Ratio Formula

The formula to calculate the senior leverage ratio divides a company’s senior debt by its EBITDA.

Where:

• Senior Debt ➝ The senior debt is the sum of all senior debt obligations, at the risk of stating the obvious.
• EBITDA ➝ On the other hand, EBITDA must be manually calculated by adding depreciation and amortization (D&A) to operating income (EBIT), at its simplest.

Since EBITDA is a non-GAAP financial measure and not standardized, the recommended route is to calculate EBITDA manually and to apply adjustments for non-cash charges and extraordinary items (i.e. non-recurring) as deemed necessary.

Management will often calculate and present EBITDA in management presentations and non-GAAP reports, but those figures should only be used for reference and never taken at face value without understanding the adjustments applied (and the logic).

By understanding how to compute and interpret the senior leverage ratio, investors can make more informed decisions about which companies to invest in based on their financial health and risk profile, while lenders can decide whether to provide debt capital to a particular borrower (and set the terms appropriately based on the risk profile).

For example, if a company has $100 million in senior debt and $25 million in EBITDA, its senior leverage ratio would be 4.0x.

Based on the company’s current EBITDA, the senior debt load is 4x the earnings metric and paying off its outstanding senior debt would take an estimated four years.

• Senior Leverage Ratio = $100 million ÷ $25 million = 4.0x

Note, there are variations of the senior leverage ratio that modify the standard senior leverage ratio formula.

For instance, one common variation is the senior debt to EBIT ratio—which excludes the depreciation and amortization (D&A), and is thereby considered a more conservative measure of risk.

Unlike EBITDA, EBIT (or “Operating Income”) does not add back non-cash charges, namely the D&A expense.

EBIT, or “Operating Income”, is recorded on the income statement, contrary to EBITDA, which is prohibited from being recognized on the income statement prepared under U.S. GAAP accounting standards.

Furthermore, there is also the senior net debt to EBITDA, which subtracts cash from senior debt based on the notion that excess cash sitting on the balance sheet can be used to paydown debt as needed.

However, the underlying concept and intent remains the same, irrespective of the variation used.

What is a Good Senior Leverage Ratio?

The target senior leverage ratio is industry-specific (and set by lenders), but in general, a ratio of 3.0x or lower is considered healthy by most practioners.

If a company’s senior leverage ratio is less than 2.0x, or between 2.0x and 3.0x, the senior debt load load is deemed manageable relative to its earnings (EBITDA or EBIT).

Therefore, a borrower’s senior debt should not exceed its EBITDA no more than 3x, barring extraordinary circumstances.

The stated benchmarks, however, are intended to be merely general guidelines, rather than stringent rules that apply across all industries (and sectors).

What is considered an “acceptable” senior leverage ratio can vary significantly based on the industry in which the company operates, including the stage at which the company is in its lifecycle.

For example, established companies in defensive sectors like utilities or consumer staples can often sustain higher ratios because of their stable cash flows and the limited competition (i.e. high barriers to entry). High-growth, early stage SaaS companies, on the other hand, are held to a much higher standard, where lower senior debt ratios are expected.

Comparisons of a company’s senior leverage ratio to its peers must only be performed against comparable companies that operate in the same (and an adjacent) industry.

Moreover, monitoring the trend of a company’s senior debt ratio across historical periods must be supported with analysis on the underlying drivers to understand the cause for the change, as opposed to a high-level glance.

If a company’s senior leverage ratio is high relative to peers or that is trending upward, that could signal a potential “red flag”, even if within the generally acceptable range.

By monitoring the senior leverage ratio over time, companies and investors—such as equity shareholders and lenders—can closely monitor whether the senior debt load is manageable and identify potential risks prior to becoming a material risk to the status of the company (i.e. continue operating as a “going concern”).

Maintaining a healthy senior leverage ratio on a consistent basis provides more financial flexibility with regard to raising capital and reduces the risk of financial distress.

But to reiterate, the fundamentals of the company and the context must be comprehended to confirm that the implied credit profile is indeed correct and supported by numerous financial metrics, not just one.

What are the Limitations of Senior Leverage Ratio?

While a useful metric, the senior leverage ratio has some limitations to be aware of, as described in the following table:

Senior Leverage Ratio Calculator — Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Senior Leverage Ratio Calculation Example

Suppose we’re tasked with measuring the leverage risk attributable to a borrower with the following financial information:

Selected Balance Sheet Data

• Senior Secured Loan = $80 million
• Senior Bonds = $40 million
• Unsecured Subordinated Bond = $20 million

Selected Income Statement Data

• Operating Income (EBIT) = $30 million
• Depreciation and Amortization (D&A) = $10 million

The first step is to determine the sum of the senior debt on the borrower’s balance sheet.

The company’s total senior debt, as of the present date, is $120 million.

• Total Senior Debt = $80 million + $40 million = $120 million

In the next step, we’ll calculate our company’s EBITDA, which equals operating income (EBIT) plus D&A.

The earnings metric—EBITDA in our illustrative exercise—equals $40 million.

• EBITDA = $30 million + $10 million = $40 million

In closing, the senior leverage ratio comes out to 3.0x, implying the total senior debt is 3 times the size of its EBITDA (and requires 3 years for repayment in-full).

• Senior Leverage Ratio = $120 million ÷ $40 million = 3.0x