Almost every company you will ever look at borrows money, and understanding why is what separates a surface read of a balance sheet from a real one. This deck takes credit from both sides at once, the company doing the borrowing and the lender deciding whether to hand the money over. You will cover why a profitable business chooses to take on debt, what a revolver or a term loan actually is, how leverage and coverage ratios get read, and what happens when the money runs out. Every term is defined from scratch, so you do not need to have seen a loan agreement or a bankruptcy before.
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Card 1 of 16
Calder Foods is profitable, sitting on cash, and carries no debt at all. Its CFO is about to sign $200 million of loans anyway. Why would a healthy company deliberately borrow money?
Debt costs less than equity and hands over no ownership, so it can lift the returns owners earn.
Lenders get paid before shareholders and often hold a claim on specific assets, so they take less risk and accept a lower return than equity investors demand. Debt also doesn’t give away ownership: if Calder borrows $200 million and earns more on that money than the interest costs, the extra profit belongs entirely to the existing shareholders. That amplifying effect is why even cash-rich companies keep some debt on the balance sheet, and it is the same logic sitting underneath every leveraged buyout you will ever model.
Card 2 of 16
An associate tells you debt is cheaper than the interest rate suggests because of the tax shield. Walk through what she means for a company paying $10 million of interest at a 25% tax rate.
Interest is deducted before tax is calculated, so borrowing shrinks the tax bill and the real cost of debt.
Interest expense is subtracted from profit before the tax charge is worked out, so borrowing lowers taxable income. On $10 million of interest at a 25% tax rate the company keeps $2.5 million it would otherwise have paid in tax, meaning the interest really costs $7.5 million. A 6% loan is closer to 4.5% in cash terms, which is the shorthand after-tax cost equals rate times one minus the tax rate. Equity has no equivalent break, since dividends come out of already-taxed profit, and that asymmetry is a big reason capital structures contain debt at all.
Card 3 of 16
What is the difference between a revolver, a term loan, and a bond?
Revolvers cover short-term swings, term loans fund a set need, bonds raise long money from investors.
A revolving credit facility, or revolver, is a pre-agreed limit the company can draw on, repay, and draw again, normally used to smooth seasonal swings in working capital and mostly left undrawn as a safety net. A term loan is a fixed amount lent by a bank or a syndicate of banks for a set period, usually at a floating rate, often repaid partly in instalments and monitored closely. A bond is borrowed from many investors at once in the capital markets, typically longer-dated, lightly monitored, and repaid in a single lump at maturity.
Card 4 of 16
Northbay Logistics is negotiating two facilities at once, one secured on its truck fleet and one unsecured. What does collateral actually do for the lender, and how does it show up in the pricing?
Collateral gives a lender named assets to seize first, which raises its recovery and cuts the rate charged.
A secured loan is backed by specific assets pledged to the lender, here Northbay’s trucks and depots. If the company stops paying, the secured lender can take and sell those assets ahead of everyone else, so it expects to get far more of its money back in a bad outcome. An unsecured lender has only a general claim on whatever is left. Because expected recovery is higher, secured debt prices meaningfully tighter, which is why companies pledge assets even though doing so limits what they can later sell or borrow against.
Card 5 of 16
Calder Foods files for bankruptcy with $600 million of cash to distribute against $900 million of claims. In what order does that money go out, and who is likely to end up with nothing?
Cash flows down a strict seniority ladder and equity is paid only once every creditor is made whole.
Recoveries follow a waterfall: the costs of running the process first, then secured lenders up to the value of their collateral, then senior unsecured bonds, then subordinated or junior debt, then preferred shares, and common equity last. Each tier must be paid in full before the next one receives anything at all. With $600 million against $900 million of claims the money runs dry partway down, so the senior unsecured lenders take a partial recovery and everything below them is wiped out. That ranking is precisely why lenders negotiate so hard over where in the structure they sit.
Card 6 of 16
What is the difference between amortising debt and a bullet maturity, and why does the choice matter for a company’s cash flow?
Amortising debt repays principal along the way, a bullet repays the whole thing on the final day.
Amortising debt requires the borrower to repay slices of the principal on a schedule, say 5% or 10% a year, so the balance shrinks steadily and the lender’s exposure falls with it. A bullet pays interest only until the last day, when the entire principal comes due at once. Amortising is harder on year-to-year cash flow but leaves little to deal with at the end. Bullets keep cash free for the business and are standard for bonds, at the cost of one very large obligation the company will almost certainly need to refinance.
Card 7 of 16
An MD glances at your page and says Northbay is four and a half turns levered. What is he measuring, and what does that number actually tell you about the company?
Debt divided by EBITDA says how many years of operating earnings it would take to repay the debt.
He means the leverage ratio, total debt divided by EBITDA, which is earnings before interest, tax, depreciation and amortisation and serves as a rough proxy for the cash a business throws off before financing costs. At 4.5x, Northbay owes about four and a half years of that figure. Bankers say turns because each turn is one multiple of EBITDA. Below roughly 2x is usually called conservative and above 6x aggressive, but the safe level depends heavily on the industry, since a utility with contracted revenue can carry far more than a cyclical manufacturer.
Card 8 of 16
Two companies both sit at 5x debt to EBITDA, but your credit analyst is relaxed about one and worried about the other. What does an interest coverage ratio tell you that the leverage ratio does not?
Coverage asks whether this year’s earnings can pay this year’s interest, not how big the debt pile is.
Interest coverage is EBITDA divided by annual interest expense, and it answers a different question: can the company actually meet what it owes right now? Leverage measures the size of the debt, but two borrowers with identical leverage can be paying very different rates. One borrowing at 4% might cover its interest five times over, while one paying 11% covers it barely twice, and the second is far closer to trouble. Anything under about 2x makes lenders uneasy, because a single weak quarter can leave the company unable to make a payment.
Card 9 of 16
Ferrow Retail’s loan caps leverage at 4.0x, tested every quarter, and this quarter it comes in at 4.2x. What kind of covenant is that, and what actually happens next?
Maintenance covenants are tested on a schedule and a breach hands lenders the right to call the loan.
That is a maintenance covenant, a test the borrower has to pass on a fixed schedule whether or not it does anything at all. An incurrence covenant, more common in bonds, only bites when the company takes an action such as raising new debt or paying a dividend. Breaching a maintenance covenant is an event of default, and in principle the lenders can accelerate, meaning demand the entire loan back immediately. In practice they usually negotiate a waiver or amendment in exchange for a fee, a higher margin, or tighter terms, because pushing a viable business into bankruptcy rarely maximises their recovery.
Card 10 of 16
What is the difference between fixed-rate and floating-rate debt, and who is carrying the interest rate risk in each one?
Fixed debt locks the borrower’s cost and leaves the lender exposed, floating debt does the reverse.
A fixed-rate loan or bond pays the same coupon for its whole life, so the borrower knows its interest bill years ahead and the lender absorbs the risk that market rates move against it. Floating-rate debt, the norm for bank loans, resets periodically at a benchmark rate plus a fixed margin, so the borrower’s cost rises and falls with the market while the lender’s return keeps pace. Floating borrowers are therefore exposed to rate rises, which is why heavily indebted companies often buy hedges that cap how far that cost can climb.
Card 11 of 16
You are drafting a credit memo and your VP says the ratios are the easy part. Beyond leverage and coverage, what does a credit analyst actually look at before agreeing to lend?
Ratios are one snapshot, real credit work is about how durable the cash flow looks under stress.
An analyst wants to know how reliable the cash flow is, so they test how cyclical the industry is, how concentrated the customer base is, whether contracts are long-dated or repriced every year, and how much of the cost base is fixed and therefore cannot be cut in a downturn. They look hard at liquidity, meaning cash on hand plus whatever is undrawn on the revolver, because companies fail when they run out of cash rather than when a ratio slips. They also weigh asset quality, the maturity profile, and whether the owners would put fresh equity in if things went wrong.
Card 12 of 16
Northbay has comfortable leverage and pays its interest easily, but $700 million of its $900 million of debt matures in a single year. Why does your credit analyst still call that a risky structure?
Debt bunched into one year has to be refinanced whether or not markets are open when it comes due.
Almost no company repays large debt out of its own pocket, it refinances, borrowing new money to retire the old. That works right up until the year the debt falls due happens to be a year when credit markets are shut, the rating has slipped, or rates have doubled. A maturity wall, meaning a large block of debt maturing in one narrow window, concentrates that risk on a single date instead of spreading it out. Treasurers manage it by staggering maturities and refinancing early, often a year or two ahead, and lenders read an unaddressed wall as a warning sign.
Card 13 of 16
Calder Foods is one notch inside investment grade, and a deal it is considering would push it into high yield. Beyond a higher coupon, what actually changes for the company if it crosses that line?
Dropping to high yield costs more, restricts more, and changes who is willing to hold the debt.
The higher coupon is the obvious cost, often a few percentage points. Less obvious is that high-yield bonds come with far more restrictive documentation, limiting extra borrowing, dividends, asset sales and acquisitions, plus call protection that makes repaying early expensive. The investor base changes too, from insurers and index funds that are only permitted to hold investment grade towards credit funds pricing each deal on its own merits, so demand is thinner and swings with sentiment. That is why some companies will shrink a deal, fund it with equity, or walk away entirely to protect the rating.
Card 14 of 16
A company misses an interest payment. Walk me conceptually through what happens next, and what people mean when they distinguish a restructuring from a Chapter 11 filing.
Default just breaks the contract, then the company and its creditors either negotiate a fix or go to court.
A default is simply a breach of the debt agreement, a missed payment or a broken covenant, and it usually opens a short grace period rather than triggering immediate seizure. From there the company and its creditors can restructure out of court, agreeing to extend maturities, cut the coupon, or swap debt for equity, which is quicker and cheaper but needs nearly everyone to consent. If they cannot agree, Chapter 11 puts the company under court protection, where an automatic stay pauses collection while a plan is negotiated, and the same seniority waterfall decides who takes losses and who ends up owning the business.
Card 15 of 16
Rates have risen sharply since Ferrow Retail last financed itself. Your MD asks how that changes what the company should be doing about its debt. Where do you start?
Higher rates hit floating debt immediately and every maturity that has to be refinanced later.
Start with whatever is already floating, because that cost repriced the moment rates moved and it feeds straight into interest coverage. Then look at the maturity profile, since anything coming due gets refinanced at today’s rates rather than the ones it was issued at, so a bond struck at 4% can roll into 8% and double the interest bill overnight. Higher rates also raise the bar for investment, so projects that cleared a low hurdle rate no longer do. Companies often respond by borrowing less, paying debt down, hedging, or shortening maturities if they expect rates to fall back.
Card 16 of 16
Ferrow Retail reports record EBITDA and is still comfortably inside every covenant, yet it runs out of money by December. Your MD asks how that is possible. How do you answer?
EBITDA is not cash, and companies fail when the cash runs out rather than when earnings look weak.
EBITDA deliberately ignores the things that actually drain cash: interest, tax, capital spending, and working capital. A retailer growing quickly has to buy inventory and pay suppliers long before customers pay it, so reported profit climbs while the bank balance falls. Add an amortisation payment, a revolver the bank declines to renew, or a maturity landing in a closed market, and a genuinely profitable business can miss a payment. That gap between accounting earnings and cash actually available is the most useful thing to carry out of credit work, and it is why analysts build all the way down to free cash flow instead of stopping at EBITDA.
Reading is not the same as remembering. Study this deck with scheduled review so the cards come back before you forget them.