Financial Ratios and Metrics

Liquidity Ratios

Liquidity ratios measure a company's ability to meet short-term obligations:

• Current Ratio: Current Assets ÷ Current Liabilities. A ratio above 1.0 means the company can cover its near-term obligations. Too high may indicate inefficient use of assets.
• Quick Ratio (Acid Test): (Current Assets − Inventory) ÷ Current Liabilities. Strips out inventory (the least liquid current asset). A more conservative measure of short-term solvency.
• Working Capital: Current Assets − Current Liabilities. The absolute dollar amount of short-term liquidity buffer.

Cash Conversion Cycle

Measures how quickly a company converts inventory and receivables into cash:

• Days Sales Outstanding (DSO): 365 ÷ Receivables Turnover (Revenue ÷ Avg AR). How long to collect from customers.
• Days Inventory Outstanding (DIO): 365 ÷ Inventory Turnover (COGS ÷ Avg Inventory). How long inventory sits before selling.
• Days Payable Outstanding (DPO): 365 ÷ Payables Turnover (COGS ÷ Avg AP). How long the company takes to pay suppliers.

Cash Conversion Cycle = DSO + DIO − DPO

Shorter = better. Negative cycles (collecting before paying) are ideal.

Profitability Metrics

• Gross Margin: Gross Profit ÷ Revenue
• Operating Margin: EBIT ÷ Revenue
• Net Margin: Net Income ÷ Revenue
• Pre-Tax Margin: Pre-Tax Income ÷ Revenue
• EBITDA Margin: EBITDA ÷ Revenue
• EBITDAR: EBITDA + Rent. Used for industries with significant leases (airlines, retail, restaurants, healthcare). The "R" stands for Rent.
• ROE: Net Income ÷ Shareholders' Equity
• ROA: Net Income ÷ Total Assets
• ROIC: NOPAT ÷ Invested Capital (most comprehensive — measures return on all capital, debt and equity)
• ROI: Gain on Investment ÷ Cost of Investment
• Earnings Yield: EPS ÷ Price per Share (inverse of P/E). Useful for comparing stock returns to bond yields.
• Equity Turnover: Revenue ÷ Avg Shareholders' Equity. Measures efficiency of equity capital.
• EPS: Net Income ÷ Diluted Shares Outstanding. Basic EPS uses actual shares; diluted EPS includes the effect of options, warrants, and convertibles.

Leverage Ratios

• Debt-to-Equity: Total Debt ÷ Shareholders' Equity (total and long-term variants)
• Debt-to-Capital: Total Debt ÷ (Total Debt + Equity). Shows debt as a proportion of total capitalization.
• Net Debt: Total Debt − Cash and Cash Equivalents. A company with $500M debt and $200M cash has $300M net debt.
• Net Debt / EBITDA: The key credit metric. Measures how many years of EBITDA it would take to repay all net debt. Lenders often set covenants at specific levels (e.g., max 4.0x Net Debt/EBITDA).
• Interest Coverage: EBIT ÷ Interest Expense. How many times the company can cover its interest payments. Below 1.0x = cannot cover interest from operations.

Efficiency and Other Metrics

• Asset Turnover: Revenue ÷ Average Total Assets. Measures how efficiently assets generate revenue. Varies by industry.
• Total Expense Ratio (TER): Total Operating Expenses ÷ Assets. Primarily used for investment funds and REITs to measure cost efficiency.
• Free Cash Flow Yield: FCF ÷ Enterprise Value. Measures cash generation per dollar of total value. Higher = potentially undervalued. A quick screening metric for acquisition targets.

ROIC — The Most Comprehensive Return Metric

ROIC = NOPAT / Invested Capital
where NOPAT = EBIT × (1 − Tax Rate)
Invested Capital = Total Debt + Total Equity − Excess Cash

ROIC measures how efficiently a company generates after-tax operating profit from ALL capital invested — both debt and equity. Unlike ROE (which only looks at the equity slice), ROIC cannot be inflated by leverage alone.

When ROE and ROIC Diverge

A company can have ROE of 35% but ROIC of only 8%. That usually means leverage is amplifying a mediocre operating return. The DuPont framework reveals this — the equity multiplier is high, but net profit margin and asset turnover are ordinary. Investors and bankers who focus only on ROE can be misled; ROIC gives the cleaner picture.

The DuPont Framework — Diagnosing ROE

DuPont analysis decomposes ROE into three drivers to show why ROE is high or low:

ROE = Net Profit Margin × Asset Turnover × Equity Multiplier

Two-step shortcut: ROE = ROA × Equity Multiplier. If ROA is flat but ROE rises, the company is adding leverage, not improving operations. The exam frequently tests this diagnostic.

Coverage Ratios — Beyond Simple Interest Coverage

Fixed Charge Coverage Ratio (FCCR)

FCCR = (EBITDA + Rent) / (Interest + Rent) = EBITDAR / Fixed Charges

Used for lease-heavy industries (airlines, retailers, restaurants). Standard interest coverage misses the rent obligation; FCCR captures it.

Debt Service Coverage Ratio (DSCR)

DSCR = Cash Available for Debt Service / (Interest + Mandatory Principal)

DSCR is more conservative than interest coverage because it includes mandatory principal repayments. A DSCR below 1.0x means the company cannot cover its scheduled debt service from operating cash flow.

Maintenance CapEx Coverage

(EBITDA − Maintenance CapEx) / Interest Expense

More conservative than EBITDA/Interest because it recognizes that some capital spending is mandatory to keep the business running. This is a common lender metric for credit analysis.

Liquidity Ratios — Interpretation and the Cash Ratio

The Current-vs-Quick Gap

If a company has a current ratio of 2.5x but a quick ratio of only 0.8x, inventory dominates its current assets. That is a warning sign if the inventory is hard to liquidate — the company may look healthy on paper but lack true short-term liquidity. This gap is commonly tested.

The Cash Ratio

Cash Ratio = (Cash + Marketable Securities) / Current Liabilities

The most conservative liquidity metric. It excludes accounts receivable (which the quick ratio includes) and answers: can the company pay current obligations with only its most liquid assets? A cash ratio below 1.0x is normal — few companies hold enough cash to cover all current liabilities immediately.

PEG Ratio Interpretation

PEG = P/E ÷ Expected Earnings Growth Rate (as whole number)

• PEG < 1.0: Stock may be undervalued relative to its growth — the market is paying less per unit of growth
• PEG ≈ 1.0: Fairly valued relative to growth
• PEG > 1.0: Stock may be expensive relative to its growth — the market is paying a premium per unit of growth

Limitation: PEG assumes the growth rate is reliable. For volatile or cyclical companies, projected growth may be unrealistic.

Rule of 40 (SaaS Quick Check)

Revenue Growth Rate (%) + EBITDA Margin (%) ≥ 40%

A quick health check for SaaS companies that balances growth against profitability. A company growing at 50% with -15% margins scores 35% (fails). A company growing at 30% with 15% margins scores 45% (passes). The concept: fast-growing companies can trade some profitability for growth, but the combined score should still exceed 40%.

Which Costs Affect Which Margins

The exam frequently tests whether you know the boundary between different profitability levels:

• Gross Margin = (Revenue − COGS) / Revenue. Affected by raw materials, manufacturing costs, product mix. SG&A does NOT affect gross margin — it sits below the gross profit line.
• EBITDA Margin = EBITDA / Revenue. Affected by COGS and SG&A, but NOT by D&A, interest, or taxes. Cutting SG&A increases EBITDA margin but leaves gross margin unchanged.
• Operating Margin = EBIT / Revenue. Includes D&A on top of COGS and SG&A. Higher depreciation reduces operating margin but not EBITDA margin.
• Net Margin = Net Income / Revenue. Includes interest and taxes. Affected by capital structure and tax rates.

Capital Structure Theory

Modigliani-Miller (M&M)

• Without taxes: Capital structure is irrelevant — WACC is constant regardless of leverage because cheaper debt is exactly offset by rising equity costs. This is the theoretical baseline.
• With taxes: Debt creates a tax shield (interest is tax-deductible), so adding debt lowers WACC and increases firm value. In this world, 100% debt would be optimal — but that ignores the costs of financial distress.

Trade-Off Theory

The real-world framework: as a company adds debt, WACC initially declines because the tax shield lowers the after-tax cost of borrowing. But beyond a point, the rising probability and cost of financial distress (bankruptcy costs, loss of customers, higher required returns from all investors) overwhelm the tax benefit, and WACC starts rising again. The optimal capital structure minimizes WACC at the point where the marginal tax benefit equals the marginal distress cost.

Operating Leverage vs. Financial Leverage

Financial leverage amplifies ROE by using debt. It magnifies both gains and losses. A company can have high ROE simply because it has very little equity — the equity multiplier in the DuPont framework captures this. High financial leverage + high operating leverage = highly volatile earnings, which limits debt capacity.

Turnover Ratios and Days Conversions — Computational Reference

Working-capital efficiency ratios come in two equivalent forms: turnover ratios (times per year) and days ratios (days of inventory or receivables or payables on hand). The two are reciprocal — one is 365 divided by the other. Fluency with both forms and the ability to move between them without a calculator pays off on dozens of exam questions, most of which are pure arithmetic against a small number of formulas.

The Four Core Formulas

AR Turnover = Credit Sales / Avg AR
DSO = 365 / AR Turnover = (Avg AR / Credit Sales) × 365

Inventory Turnover = COGS / Avg Inventory
DIO (a.k.a. DSI) = 365 / Inv Turnover = (Avg Inv / COGS) × 365

AP Turnover = COGS / Avg AP
DPO = 365 / AP Turnover = (Avg AP / COGS) × 365

Fixed Asset Turnover = Revenue / Net PP&E

The Two Numerator Conventions

Observe which numerator each formula uses — this is the single most common source of error:

• AR turnover uses Credit Sales (revenue). The question is how quickly customer-owed revenue is collected, so the denominator-building flow is sales.
• Inventory turnover uses COGS. The question is how quickly the inventory pool turns over through sales at the cost basis, not at retail. Using revenue instead of COGS gives a number that is too high by roughly the gross margin ratio.
• AP turnover uses COGS. The question is how quickly the company pays its suppliers, and purchases flow through COGS. Using revenue would overstate AP turnover and understate DPO.

Memorize: AR uses sales, inventory and AP use COGS. Missing this distinction is the single biggest source of exam errors in this topic area.

Worked Examples

Each example uses the same formula pattern. Fluency means recognizing them on sight and solving in under twenty seconds.

DSO from AR and credit sales: A company reports $40 million average AR and $730 million annual credit sales.

• DSO = ($40M / $730M) × 365 = 20 days
• Equivalently, AR Turnover = $730M / $40M = 18.25x, and 365 / 18.25 = 20 days

Inventory turnover from COGS and average inventory: A retailer reports $800 million COGS and $200 million average inventory.

• Inventory Turnover = $800M / $200M = 4.0x
• Equivalently, DIO = ($200M / $800M) × 365 = 91.25 days

DPO from COGS and average AP: A manufacturer reports $600 million COGS and $60 million average AP.

• DPO = ($60M / $600M) × 365 = 36.5 days
• Equivalently, AP Turnover = $600M / $60M = 10.0x, and 365 / 10.0 = 36.5 days

DIO from COGS and average inventory: A distributor reports $730 million COGS and $60 million average inventory.

• DIO = ($60M / $730M) × 365 = 30 days
• Equivalently, Inventory Turnover = $730M / $60M = 12.17x, and 365 / 12.17 = 30 days

Moving Between the Two Forms

Given one, the other follows immediately from the 365 reciprocal. If AR Turnover is 12.0x, then DSO = 365 / 12.0 = 30.4 days. If DIO is 73 days, then Inventory Turnover = 365 / 73 = 5.0x. If AP Turnover is 8.0x, then DPO = 365 / 8.0 = 45.6 days. This shortcut handles the questions that give you one ratio and ask for its counterpart, which are among the easiest points on the exam.

Fixed Asset Turnover — Interpretation Tip

Fixed Asset Turnover = Revenue / Net PP&E. A company with unusually high fixed asset turnover relative to peers may not actually be more efficient — the denominator may be low because the company operates older, fully depreciated equipment with a low net book value. High ratios can also reflect heavy use of operating leases (historically off-balance-sheet; now partially on-balance-sheet under ASC 842) that keep PP&E small. New capital investment increases PP&E and temporarily depresses the ratio until the new assets produce revenue.

Cash Conversion Cycle — Assembly and Sensitivity

The Cash Conversion Cycle measures the number of days between the company’s cash outlay for inventory and its cash collection from customers — the length of time the business must fund working capital out of its own resources before the operating cycle closes. A shorter CCC means cash circulates faster; a longer CCC means more cash tied up in the business.

The Assembly Formula

CCC = DSO + DIO − DPO

The intuition is straightforward:

• DIO is how long cash is parked in inventory before sale — a use of time
• DSO is how long cash is parked in receivables after sale before collection — another use of time
• DPO is how long the company defers payment to suppliers — a financing offset that reduces the cycle

Note the sign on DPO: it is subtracted. Adding DPO instead of subtracting it is the single most common error. Longer DPO means the company is holding its cash longer before paying suppliers, which is a good thing for working-capital efficiency, which is why it reduces rather than extends the CCC.

Worked Examples

The calculation is always the same three-line assembly:

• DSO 30, DIO 40, DPO 20: CCC = 30 + 40 − 20 = 50 days
• DSO 45, DIO 60, DPO 30: CCC = 45 + 60 − 30 = 75 days
• DSO 35, DIO 45, DPO 40: CCC = 35 + 45 − 40 = 40 days
• DSO 30, DIO 80, DPO 45: CCC = 30 + 80 − 45 = 65 days

Sensitivity to Individual Components

Because the CCC is additive in DSO and DIO and subtractive in DPO, sensitivities follow directly from the sign of each term:

• DPO rises by X days → CCC falls by X days. If a manufacturer extends its DPO from 30 to 60, CCC decreases by 30 days. The company holds cash longer before paying suppliers, shrinking the cycle.
• DPO falls by X days → CCC rises by X days. If a retailer’s DPO declines from 30 to 20, CCC rises by 10 days. Faster payment to suppliers lengthens the cash cycle and forces the company to fund working capital from other sources.
• DSO or DIO rises by X days → CCC rises by X days. The company is holding its cash in AR or inventory longer.
• DSO or DIO falls by X days → CCC falls by X days. The company is releasing cash faster from AR or inventory.

Why the CCC Matters

A long CCC forces the business to finance its working capital through debt, equity, or operating cash, all of which have costs. A negative CCC — rare but valuable — means suppliers effectively finance the business: the company collects from customers before paying its suppliers. This is the structural advantage enjoyed by cash-collecting retailers (Amazon, Costco) and subscription businesses with upfront billing (SaaS annual contracts). Negative working capital is sometimes a red flag in distressed situations but is a sign of operational excellence for well-run businesses with recurring demand.

Dividend Mechanics and the Sustainable Growth Rate

Four related metrics describe how a company splits earnings between shareholder payouts and internal reinvestment. All four connect to each other through the same two ratios (payout and retention), so solving any dividend question usually comes down to identifying which component you are given and which you are asked for.

The Four Formulas

Dividend Payout Ratio = DPS / EPS = Dividends / Net Income
Retention Ratio = 1 − Payout Ratio
Dividend Yield = DPS / Share Price
Sustainable Growth Rate (SGR) = ROE × Retention Ratio

Building Up: Dividend Yield from P/E and Payout

Dividend yield can be derived even when you are not given DPS and share price directly. Two equivalent paths:

• From DPS and price: Yield = DPS / Price (the direct definition)
• From earnings yield and payout: Yield = (1 / P/E) × Payout Ratio = Earnings Yield × Payout

Worked example. A utility trades at $50 per share with EPS of $4.00 and a 25% payout.

• DPS = $4.00 × 0.25 = $1.00
• Yield = $1.00 / $50.00 = 2.0%
• Cross-check via P/E: P/E = $50 / $4 = 12.5x; earnings yield = 1/12.5 = 8%; div yield = 8% × 25% = 2.0% ✓

Worked example. A company trades at 20.0x P/E with a 60% payout ratio. What is the implied dividend yield?

• Earnings yield = 1 / 20.0 = 5.0%
• Dividend yield = 5.0% × 60% = 3.0%

Computing Payout from DPS and EPS

When the question gives DPS and EPS directly, payout is just the ratio of the two.

Worked example. A company reports EPS of $8.00 and declared $2.00 in common dividends per share. What is the payout ratio?

• Payout = $2.00 / $8.00 = 25.0%
• Retention = 1 − 25.0% = 75.0%

Sustainable Growth Rate

The sustainable growth rate is the maximum rate at which a company can grow earnings without issuing new external equity. The logic: retained earnings fund growth at the rate the business generates returns on equity. If ROE is 20% and the company retains 60% of earnings, it can grow at 20% × 60% = 12% per year purely from internal funds.

Worked examples.

• ROE 20%, payout 40%: Retention = 60%; SGR = 20% × 60% = 12.0%
• ROE 15%, payout 20%: Retention = 80%; SGR = 15% × 80% = 12.0%
• ROE 25%, payout 60%: Retention = 40%; SGR = 25% × 40% = 10.0%
• ROE 20%, payout 25%: Retention = 75%; SGR = 20% × 75% = 15.0%

The formula assumes no change in financial leverage and constant ROE. The common error is to multiply ROE by the payout ratio instead of the retention ratio — the formula uses the fraction of earnings kept in the business, not the fraction paid out. If ROE is 20% and payout is 40%, the wrong answer uses 40% directly and produces 8%; the right answer uses (1 − 40%) = 60% and produces 12%.

Strategic Implication

The SGR framework tells management which payout policy is compatible with a target growth rate. A company that aims to grow earnings faster than its SGR must either raise new equity, increase leverage (which raises ROE and the SGR), or accept slower growth. The exam tests the formula primarily, but interpretive questions also appear: when companies maintain high dividends despite slow growth, it often signals a mature business with limited reinvestment opportunities.

PEG Ratio and Earnings Yield — Computation Focus

PEG and earnings yield are two of the most frequently tested valuation-related calculations. Both are derived directly from the P/E multiple, and both are pure arithmetic. The single source of error across exam questions is the growth-rate scaling convention on PEG and the confusion of earnings yield with the P/E ratio itself.

Earnings Yield — The Reciprocal of P/E

Earnings Yield = EPS / Price = 1 / (P/E)

Earnings yield expresses earnings per dollar of stock price and is the inverse of the P/E multiple. A higher P/E corresponds to a lower earnings yield and a richer valuation. A P/E of 10x implies a 10.0% earnings yield; a P/E of 20x implies 5.0%; a P/E of 25x implies 4.0%.

Worked examples.

• P/E = 12.5x → Earnings Yield = 1 / 12.5 = 8.0%
• P/E = 16.0x → Earnings Yield = 1 / 16.0 = 6.25%
• Share price $50, EPS $4.00 → Earnings Yield = $4.00 / $50.00 = 8.0% (equivalent to 1 / 12.5)

Accretion/Dilution Tie-In

Earnings yield is the key input for the debt-funded acquisition accretion shortcut. A 100% debt-funded deal is accretive to EPS when the target’s earnings yield exceeds the acquirer’s after-tax cost of debt. If a target trades at 12.5x P/E (8% earnings yield) and the acquirer borrows at 4% after-tax, the deal is accretive because 8% exceeds 4%. If the target trades at 25x P/E (4% yield) and the cost of debt is the same 4%, the deal is roughly EPS- neutral before synergies.

This is why accretion/dilution questions ask for the target’s earnings yield — not the P/E directly. Converting between P/E and earnings yield is a setup step, not the whole question.

PEG Ratio — P/E Scaled by Growth

PEG = P/E / Expected Growth Rate (as a whole number)

The PEG ratio attempts to adjust P/E for growth differences. A company growing earnings 25% per year can justify a higher P/E than a company growing at 5%, but a P/E multiple in isolation does not tell you whether the multiple is reasonable given the growth expected.

The most common error: dividing by the growth rate expressed as a decimal (0.25) instead of a whole number (25). A company with a P/E of 25x and 25% growth has a PEG of 25 / 25 = 1.00x, not 25 / 0.25 = 100.

Worked Examples

• P/E 45x, growth 30% → PEG = 45 / 30 = 1.50x
• P/E 20x, growth 15% → PEG = 20 / 15 = 1.33x
• P/E 30x, growth 20% → PEG = 30 / 20 = 1.50x
• P/E 15x, growth 20% → PEG = 15 / 20 = 0.75x
• P/E 50x, growth 25% → PEG = 50 / 25 = 2.00x
• P/E 40x, growth 25% → PEG = 40 / 25 = 1.60x

Interpretation Shortcuts

• PEG < 1.0: The stock may be inexpensive relative to its growth rate — growth is more than compensating for the P/E multiple
• PEG ≈ 1.0: The P/E is roughly proportional to growth — fair valuation on this metric
• PEG > 1.0: The stock trades rich relative to growth — the multiple may exceed what growth supports

The canonical comparison question pits two companies with different P/Es and different growth rates. Company A at 20x P/E with 25% growth has a PEG of 0.8x. Company B at 15x P/E with 10% growth has a PEG of 1.5x. Company A appears cheaper on PEG despite a higher P/E because its growth rate more than compensates for the premium multiple.

Caveats: the PEG framework is fragile when growth rates are low (PEG becomes very sensitive to small changes in the denominator), when earnings are negative or near zero, or when the forecast horizon is very short. It is also silent on balance- sheet and cash-flow quality. Use PEG as one input, not a single- variable valuation verdict.

Leverage Ratio Variants — Total, Senior, Net, Debt-to-Cap

Leverage ratios come in several variations that look similar but answer different questions. Credit agreements, rating agency frameworks, and LBO models each reference specific definitions, and misapplying a definition by a single line can substantially change the conclusion. This reference consolidates the variations most heavily tested.

Total Leverage Ratio

Total Leverage = Gross Debt / EBITDA

Uses gross debt — no cash offset. Measures how many years of current EBITDA would be required to retire all debt outstanding, assuming EBITDA is fully available for debt service.

Worked example. A company has $600 million of senior secured term loans, $150 million of EBITDA, and $200 million of cash.

• Total Leverage = $600M / $150M = 4.00x
• Cash is not netted against debt in this ratio. Using net debt here would give $400M / $150M = 2.67x — a common trap.

Net Leverage Ratio

Net Leverage = Net Debt / EBITDA
Net Debt = Gross Debt − Cash and Cash Equivalents

Uses net debt — cash is deducted from gross debt. The rationale is that cash on the balance sheet could theoretically be used to pay down debt. Net leverage is the more common headline leverage metric reported by companies and financial media.

Worked example. A company has $800 million of senior secured debt, $200 million of cash, and $250 million of EBITDA.

• Net Debt = $800M − $200M = $600M
• Net Leverage = $600M / $250M = 2.40x

Senior Leverage Ratio

Senior Leverage = Senior Secured Debt / EBITDA

Includes only senior secured debt in the numerator. Subordinated debt, mezzanine debt, and other junior instruments are excluded. Lenders to senior debt tranches focus on this ratio to evaluate their security position.

LBO Capacity Sizing Using Senior and Total Leverage

In LBO credit agreements, lenders commonly specify separate leverage caps for senior and total debt. The difference between the two defines the room for subordinated or mezzanine layers.

Worked example. A target generates $100 million of EBITDA. Lenders allow 6.0x total leverage and 4.0x senior leverage. If senior debt is fully maxed out, what is the maximum subordinated debt capacity?

• Maximum senior debt = 4.0x × $100M = $400M
• Maximum total debt = 6.0x × $100M = $600M
• Subordinated debt capacity = $600M − $400M = $200M

This sizing framework drives both capital-structure design and the amount of sponsor equity required to close the deal.

Debt-to-Capitalization

Debt-to-Capitalization = Total Debt / (Total Debt + Total Equity)

Measures what percentage of the company’s capital structure is funded by debt. Unlike Debt/EBITDA, this ratio is a balance-sheet structural measure rather than a cash-flow coverage measure. Note that cash is not typically netted against debt in this ratio; it uses gross debt in the numerator.

Worked examples.

• $400M debt, $600M equity, no cash: D/Cap = $400M / ($400M + $600M) = $400M / $1,000M = 40.0%
• $300M debt, $500M equity, $50M cash (ignored): D/Cap = $300M / ($300M + $500M) = $300M / $800M = 37.5%
• $200M senior + $100M sub debt, $700M equity: Total debt is $300M; D/Cap = $300M / $1,000M = 30.0%
• $800M senior + $200M sub debt, $500M equity: Total debt is $1,000M; D/Cap = $1,000M / $1,500M = 66.7%

Net Debt-to-Capitalization Variant

A Net Debt-to-Cap variant uses net debt in both numerator and denominator:

Net Debt-to-Cap = Net Debt / (Net Debt + Equity)

Worked example. $500M senior debt, $300M common equity, $100M cash.

• Net Debt = $500M − $100M = $400M
• Net Debt-to-Cap = $400M / ($400M + $300M) = $400M / $700M = 57.1%

Summary — Matching the Ratio to the Question

• If the question asks about leverage on earnings (EBITDA in the denominator), and does not say “net”, use gross debt — that’s Total Leverage
• If the question says “Net Leverage”, subtract cash from debt before dividing by EBITDA
• If the question asks about senior leverage, include only senior secured debt
• If the question asks about Debt-to-Capitalization, put total debt over total debt plus equity — cash is ignored unless the question specifies Net Debt-to-Cap
• If the question asks about LBO capacity, the difference between total leverage cap and senior leverage cap defines subordinated debt capacity

Interest Coverage Variants — From Loosest to Strictest

The exam tests three common interest coverage ratios that rank from most generous to most conservative. The same company can look healthy under one ratio and stretched under another, depending on how much of its non-cash and reinvestment burden is subtracted from the numerator.

Worked Example — Same Company, Three Ratios

A manufacturer reports EBITDA of $200 million, D&A of $30 million (so EBIT is $170 million), maintenance CapEx of $60 million, and interest expense of $40 million.

EBITDA / Interest = $200M / $40M = 5.00x
EBIT / Interest = $170M / $40M = 4.25x
(EBITDA − CapEx) / I = $140M / $40M = 3.50x

The spread between 5.00x and 3.50x tells the credit story. A lender focused only on EBITDA / Interest sees comfortable coverage; a lender using the capex-adjusted version sees a company whose cushion is thinner than the headline ratio suggests. When CapEx materially exceeds D&A, the (EBITDA − CapEx) ratio is the most realistic picture of sustainable debt service capacity.

Fixed Charge Coverage for Lease-Heavy Industries

Standard interest coverage seriously understates the financial burden for airlines, retailers, and restaurant operators — industries where lease or rent payments rival interest expense in magnitude. Credit analysts replace interest coverage with FCCR, which adds the lease expense to both sides of the ratio.

FCCR = (EBITDA + Rent or Lease Expense) / (Interest + Rent or Lease)
= EBITDAR / Fixed Charges

Worked Example — Regional Airline

A regional carrier reports $400 million of EBITDA, $100 million of cash interest expense, and $150 million of aircraft lease expense.

EBITDAR = $400M + $150M = $550M
Fixed charges = $100M + $150M = $250M
FCCR = $550M / $250M = 2.20x

A plain interest coverage ratio would show $400M / $100M = 4.00x — a figure that looks healthy until you notice the company also owes $150M of lease payments next year. FCCR of 2.20x is the more honest picture.

ASC 842 and Operating Leases on the Balance Sheet

Under ASC 842, operating leases are capitalized as right-of-use assets and lease liabilities on the balance sheet. For leverage calculations, these lease liabilities are generally treated as debt-like and included in total debt when computing Debt-to-Capitalization or Total Leverage. A retailer that looks de-levered on a pre-ASC-842 basis may look materially different once store leases are grossed up on the balance sheet.

Capitalized Interest — The Hidden Borrowing Cost

GAAP allows a company to capitalize interest incurred during the construction of a long-lived asset, adding it to the carrying value of the asset rather than expensing it on the income statement. The effect: reported interest expense understates the company's true borrowing cost.

This matters most for:

• Real estate developers — interest during construction is routinely capitalized into project cost
• Homebuilders — land development and construction interest is capitalized into inventory
• Utilities and midstream operators — interest on long-lived infrastructure projects
• Shipbuilders and large-equipment manufacturers — interest during extended build cycles

Adjustment for Economic Coverage

For a more complete interest coverage ratio, add capitalized interest back to the denominator:

Adjusted Interest = Interest Expense (P&L) + Capitalized Interest
Adjusted Coverage = EBITDA / Adjusted Interest

A homebuilder reporting $20 million of interest expense and $30 million of capitalized interest actually carries $50 million of total economic interest. Coverage ratios built off the $20 million figure alone would dramatically overstate debt service capacity. Rating agencies and sophisticated credit investors routinely make this adjustment; the exam tests whether you recognize it.

PIK Debt in Coverage Ratios

Payment-in-Kind (PIK) interest accrues to the principal balance of the debt rather than being paid in cash each period. PIK features show up in distressed capital structures, sponsor-backed LBO tranches, second-lien paper, mezzanine notes, and holdco debt. Some instruments have a PIK toggle that lets the issuer choose cash or PIK each period.

How PIK Is Treated in Coverage

Under GAAP, PIK interest is still interest expense on the income statement — it is accrued even though no cash is paid. For standard interest coverage ratios, PIK interest is included in the denominator because it represents a real financing cost: the debt balance grows, and the company will eventually owe a larger principal at maturity or refinancing.

Worked Example — Why PIK Treatment Matters

A sponsor-owned company reports $100 million of EBITDA, $10 million of cash interest, and $15 million of PIK interest.

Standard Interest Coverage = $100M / ($10M + $15M) = $100M / $25M = 4.00x
Cash Interest Coverage = $100M / $10M = 10.00x

The gap between 4.00x and 10.00x is significant. Cash coverage of 10.00x suggests near-term liquidity is fine — the company can easily fund this year's cash coupon. But standard coverage of 4.00x tells the longer-run story: the debt balance is growing via the PIK accrual, and that future principal will eventually need to be serviced. Excluding PIK from the denominator (to get the 10.00x figure) overstates debt capacity and is a common analyst mistake.

NOPAT, NOLs, and Invested Capital — Cleaning Up Return Metrics

ROIC is only as meaningful as the cleanliness of NOPAT and Invested Capital. Three adjustments regularly come up on the exam and in real credit or banking work.

1. Use the Marginal Tax Rate in NOPAT

NOPAT = EBIT × (1 − Marginal Tax Rate)

Use the marginal (statutory) tax rate rather than the effective rate. The effective rate can be distorted by one-time items, foreign tax differentials, or NOL utilization that does not reflect steady-state operating economics. NOPAT is meant to represent normalized after-tax operating profit as if the company were fully taxable at its long-run rate.

2. NOLs and DTAs — How They Affect Return Metrics

A Net Operating Loss (NOL) carryforward lets a company reduce future cash taxes once it returns to profitability. If the benefit is more likely than not to be realized, GAAP requires recognition of a Deferred Tax Asset on the balance sheet.

• NOPAT is generally NOT adjusted for NOLs — the marginal-rate convention already normalizes taxes to the steady-state view. The cash tax benefit of the NOL shows up separately in a DCF as a reduction to future cash taxes.
• Invested Capital excludes non-operating DTAs (including NOL-related DTAs) because they are not capital deployed in the business. Leaving them in the denominator understates ROIC.

3. Invested Capital Adjustments

The cleaner the denominator, the more meaningful ROIC becomes. Common adjustments:

• Subtract excess cash and marketable securities — idle capital that is not generating operating returns
• Subtract non-operating DTAs — NOL carryforwards, pension-related DTAs, and other non-core tax items
• Some analysts subtract goodwill to arrive at Return on Tangible Invested Capital, showing the return on capital actually deployed rather than premium paid in past acquisitions

CAPM Build and Hamada Beta Relevering — Full Walkthrough

CAPM — Cost of Equity Components

Cost of Equity = Rf + β × (Rm − Rf)
= Rf + β × Equity Risk Premium

Why Relever Peer Betas

The beta of any levered equity reflects two things: the underlying business risk (what the company does) and the financial risk (how much debt it carries). Peers in the same industry share the business risk but differ in capital structure. To isolate the business risk, unlever each peer's beta; to apply that risk to the target, relever to the target's own D/E.

Hamada (unlever): βU = βL / [1 + (1 − T) × D/E]
Hamada (relever): βL = βU × [1 + (1 − T) × D/E]

Full Worked Example — Unlever, Relever, Build Cost of Equity

The target is a private industrial company. Analyst inputs:

• Peer levered beta (median of three publics): 1.30
• Peer D/E (median): 0.80
• Target D/E: 0.40
• Marginal tax rate: 25%
• Risk-free rate (10-year Treasury): 4.2%
• Equity Risk Premium: 5.5%

Step 1 — Unlever peer beta:
βU = 1.30 / [1 + (1 − 0.25) × 0.80]
= 1.30 / [1 + 0.60]
= 1.30 / 1.60 = 0.81

Step 2 — Relever to target D/E:
βL = 0.81 × [1 + (1 − 0.25) × 0.40]
= 0.81 × [1 + 0.30]
= 0.81 × 1.30 = 1.06

Step 3 — Cost of equity via CAPM:
Re = 4.2% + 1.06 × 5.5% = 4.2% + 5.8% = 10.0%

Because the target is less leveraged than its peers (D/E 0.40 vs 0.80), its relevered beta (1.06) is lower than the peer's levered beta (1.30). That makes intuitive sense: less debt means less equity risk, even though the underlying business risk is identical. The exam frequently tests whether you can run this three-step calculation end to end.

Callable Bonds and Yield to Worst in WACC

WACC uses the market yield on the company's debt — not the coupon rate — to estimate pre-tax cost of debt. For a plain non-callable bond, that market yield is simply yield to maturity. For a callable bond, the question gets more complicated.

Why YTM Is Not Appropriate for Callable Bonds

A callable bond gives the issuer the right to redeem the bond before maturity, usually at a small premium to par. If rates fall or the issuer's credit improves, the issuer will call the bond and refinance more cheaply. That leaves the investor with the lower of two yields: yield to maturity (if not called) or yield to call (if called). A rational pricing framework assumes the issuer will exercise the option when it hurts the investor most.

Yield to Worst = min(YTM, YTC)

Worked Example — Cost of Debt for a Callable Issue

A company has senior secured notes outstanding with an 8% coupon, callable in three years at 103, ten years to maturity, currently trading at a premium.

Pre-tax cost of debt = 6.8%
After-tax cost of debt = 6.8% × (1 − 25%) = 5.1%

Using YTM of 7.3% would overstate the cost of debt because it ignores call risk. The coupon rate of 8.0% reflects what was contracted at issue, not the current market yield — it should never be used in WACC for a bond trading away from par. For a non-callable bond, YTM alone is the appropriate measure; the YTW refinement only applies when the bond has a call feature.