Basic, lesson 1 of 3
Business risk before ratios
Ratios describe one year. The business decides whether next year looks like it. Lenders start with what the company sells, to whom, and what it has to spend to keep selling it.
9 min, 3 checks
1Five questions before any number
A loan is a bet that cash flow keeps arriving for five to seven years. Before leverage, a lender wants to know how predictable that cash flow is and what could cut it off. Most credit committees ask some version of the same five questions.
- How does it make money, and how much of revenue repeats? Contracts, subscriptions, and consumables repeat. Projects and big one-off orders do not.
- Who pays it? A top customer at 25% of revenue is one phone call away from a 25% revenue problem.
- What does it have to spend to stay in business? Capex intensity and working capital needs decide how much EBITDA turns into cash.
- How cyclical is demand? A business that fell 30% in the last recession can do it again.
- Why does it win? Switching costs, regulation, scale, or a contract that is hard to replace. Without one, margins drift toward the competition's.
Check 1
Two borrowers have the same EBITDA and leverage. Which one is usually the better credit?
2How much EBITDA turns into cash
Two companies can report the same margin and leave a lender with very different cash. The gap is capex and working capital. A software company might spend 2% of revenue on capex. A trucking company might spend 15% just to keep its fleet from aging.
Worked example
Same revenue, different cash
- 1Ridgeway Labs: revenue $200m, EBITDA $40m, capex $4m. EBITDA minus capex: $36m, which is 90% of EBITDA.
- 2Harbor Freightlines: revenue $200m, EBITDA $50m, capex $30m. EBITDA minus capex: $20m, which is 40% of EBITDA.
- 3At 4.0x leverage, Ridgeway carries $160m of debt and Harbor carries $200m.
- 4Ridgeway's $36m covers 22.5% of its debt each year. Harbor's $20m covers 10%.
Harbor has the higher EBITDA and the weaker credit. Lenders often size capital-heavy borrowers on EBITDA minus capex, not EBITDA.
Check 2
A company has EBITDA of $60m and capex of $24m. What share of EBITDA is left after capex, in percent?
Check 3
Why does a lender care more about cyclicality than an equity investor buying at a low price might?
Terms in this lesson: Capital expenditures, EBITDA.
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