Julian Shocron: Chapter 3, Debt and Safety

The bakery borrowed 200 to buy its ovens. Debt is not good or bad by itself; the useful question is how comfortably the business carries it. Two ratios do most of the work.

Net debt

The bakery also keeps 30 in its account. If it chose to, it could hand that 30 to the lender tomorrow, so analysts often look at the borrowing left after counting the cash:

200 − 30 = 170 of net debt.

Leverage: net debt to EBITDA

Divide net debt by the EBITDA from Chapter 1:

170 ÷ 170 = 1.0x

Read it as: one year of operating earnings, before equipment wear, interest and tax, would cover what is owed. Lower means a lighter load. It is a rough yardstick, since EBITDA is not cash (Chapter 2 showed how much smaller free cash flow is), and a full payoff in one year would never really happen.

Coverage: can it pay the interest?

The loan costs 10% a year, so interest is 20. Compare it with operating income:

150 ÷ 20 = 7.5x

Operating profit could pay this year's interest seven and a half times over. That is a healthy cushion for a small shop.

Stress test

What if the rate jumps to 15% on the same 200? Interest becomes 30, and coverage drops to 150 ÷ 30 = 5x. Still comfortable, but a third of the cushion is gone without the bakery selling a single loaf less. Rates matter even when operations do not change.

What these ratios miss

They are snapshots of one year. A bad season, a lost customer or a broken oven would lower operating income and hit both ratios at once. They also say nothing about when the loan must be repaid. Read them as a first look, not a verdict.

Quick check

• 200 × 10% = 20 · 200 × 15% = 30
• 170 ÷ 170 = 1.0 · 150 ÷ 20 = 7.5 · 150 ÷ 30 = 5

Assumption used here: the 15% rate is a hypothetical stress case; the loan balance stays at 200.

Related note: Julian Shocron on debt to EBITDA. Previous: Chapter 2 · Next: Chapter 4, What the bakery is worth.