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Based on the most helpful WSO content, here's what you need to know about measuring credit risk and the use of leverage versus Debt/EV:
Measuring Credit Risk
Leverage: - Definition: Leverage typically refers to the ratio of a company's debt to its equity or EBITDA. It is a measure of how much debt a company has relative to its earnings or equity. - Usage: Leverage is commonly used on the sell side. It provides a straightforward measure of a company's debt burden relative to its earnings, which is crucial for understanding the company's ability to service its debt.
Debt/EV (Enterprise Value): - Definition: Debt/EV is the ratio of a company's total debt to its enterprise value. Enterprise value is the total value of a company, including its market capitalization and debt, minus cash. - Usage: Debt/EV is often used on the buy side. This metric is useful for comparing companies with different capital structures and for assessing the relative debt burden across different tranches of debt.
Key Considerations
Sell Side Preference for Leverage:
Buy Side Preference for Debt/EV:
Conclusion
By understanding the context in which each metric is used, you can better determine which one to focus on based on your specific needs and the perspective you are analyzing from.
Sources: Overview of Leveraged Finance, Overview of Leveraged Finance, January 2016 Data Update 6: Debt, the double edged sword, Oil and Gas Overview
Looking at pure “leverage” is not very helpful. If a business is levered 5x, is that a lot of leverage? For a 15x software business that may be a very manageable debt quantum, whereas for a 6x coal miner that feels extremely aggressive.
Using debt/EV (aka low to value, or LTV) helps frame the level of debt in the context of what the business is actually worth.
Thank you ! Isn’t there also an issue with loan to value because it assumes a linear relationship, whereas let’s say you have a biotech company its 6x levered but trading at 40x, the loan to value would look good but if there is a macro event or increased competition that equity cushion would drop fast. Appreciate the help.
Correct, see this mistake often in credit especially among software lenders. Of course when the company is maintaining 20%+ CAGR growth your value coverage is great. But how sensitive is your valuation to a down year? If your FCF negative SaaS company can only deliver high single digits growth (god forbid stagnation or decline) you aren’t going to get anywhere near 20-25x multiples and all of a sudden your LTV is horrific.
Thats not to say these are bad investments, but see a lot of relationship lenders falling into this trap where you’re essentially taking equity risk for debt returns.
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