Solvency and leverage

In depth

Leverage ratios and how they connect

The leverage ratios all compare the two ways a business finances its assets: by owing (liabilities) or by owning (equity). Because total assets = total liabilities + equity, they carry much the same information and can be converted into each other:

Lantern 2027: $1 + 4.22 = 5.22$, and $1 \div (1 - 0.808) = 5.22$. The equity multiplier says Lantern controls $5.22 of assets for each dollar of equity; it reappears in the DuPont analysis of return on equity in module 3. The debt-to-capital ratio uses interest-bearing debt only: of the long-term funding provided by lenders and owners together, how much came from lenders? Lantern’s rose from 41.4% to 50.9%.

Which liabilities matter? Trade payables, wages, taxes and unearned revenue are owed, but they arise from operating and they carry no interest; a lender worries most about claims that rank alongside its own and charge interest. Lantern’s 2027 liabilities split three ways: $65,250 of interest-bearing debt (24.6%), $173,379 of lease liabilities (65.4%) and $26,436 of operating liabilities (10.0%).

The brewer plan’s rate is the annual rate implied by 24 payments of $1,050 for a $24,000 brewer (0.394% a month × 12). The line of credit was drawn in two $12,000 tranches, on 1 September and 1 November.

Vendor finance is debt

Lantern bought its cold-brew brewer on the supplier’s plan: 24 monthly payments of $1,050, $25,200 in all, for a machine whose cash price is $24,000. It recorded the brewer and an instalment note at $24,000, and the $1,200 difference is interest, spread over the plan at its implied interest rate (F04 found it cheaper than Coastline’s 7.2% loan). The supplier is a lender in all but name, and the plan is interest-bearing debt with a repayment schedule. Vendor financing of this kind must be counted with the bank loans; had Lantern recorded it with its accounts payable, its debt ratios would look lower than its real borrowing.

Coverage: can earnings carry the debt?

Interest coverage (times interest earned) divides EBIT by interest expense. EBIT is used because interest is paid out of earnings before tax; for Lantern, which has no income outside its operations, EBIT is operating income. Lantern’s fell from $37{,}716 \div 1{,}200 = 31.43$ to $32{,}787 \div 2{,}879 = 11.39$. EBITDA coverage adds back depreciation and amortisation, which use no cash in the year, and fell less steeply, from 35.43 to 18.27. Because both earnings and interest are flows over the same period, coverage ratios are not distorted by 2026’s ten months.

Two cautions. First, 2026’s EBIT was earned before Ana took any salary; the $48,000 she was paid in 2027 alone is larger than 2027’s EBIT, so 2026’s 31.43 flatters the business. Second, coverage counts interest, not principal. $51,091 of Lantern’s debt principal falls due in 2028 (the $24,000 line may be renewed, but the bank need not renew it), more than the $42,231 its 2027 EBITDA would leave after interest and tax. A lender looking at repayments as well uses a debt-service measure, comparing cash flow with interest plus scheduled principal.

Net debt to EBITDA asks how many years of EBITDA would repay the debt, net of cash. Net debt is debt minus cash; Lantern’s was −$12,940 at the end of 2026 (more cash than debt) and $58,719 at the end of 2027, or 1.12 times EBITDA. Because it divides a balance by a flow, a part-year needs annualising: 2026’s ten-month EBITDA of $42,516 is $51,019 a year, giving −0.25 rather than −0.30. Lenders often set a maximum for this ratio in loan agreements, and define both sides carefully.

Leases as debt

An operating lease commits the lessee to fixed payments for years, like a loan used to buy the asset. Since ASC 842 (effective for public companies for periods beginning after 15 December 2018, and for other entities three years later), lessees record that commitment: a right-of-use asset and a lease liability at the present value of the payments. Lantern’s cafés added $202,255 of each on 1 March 2027, discounted at 7.2%; by the year end the liability was $173,379. The liability is on the balance sheet, so it is already in the debt ratio and liabilities to equity. Whether it also belongs in “debt” is the analyst’s choice: ASC 842 itself characterises operating lease liabilities as operating liabilities rather than debt, so adding them to debt is an adjustment the analyst makes, and states, to see the business’s fixed commitments in full.

If the lease liability is counted as debt, the income statement must be adjusted to match, or the ratios mix two bases. Treat the lease as a loan throughout: split the $40,000 lease cost into its interest part, $11,124 (the accretion on the liability), and its amortisation part, $28,876. Move the interest below EBIT into interest expense, and add the amortisation to depreciation and amortisation.

Adjusted EBITDA adds back the whole lease cost, since the lease is now treated as financing. Adding the lease liability to debt but keeping EBITDA after the lease cost gives net debt ÷ EBITDA of 4.41: debt on one basis, earnings on another.

The adjustment changes the picture more than any other in Lantern’s analysis. Interest coverage falls from 11.39 to 3.14: once the cafés’ rent is treated as financing, nearly a third of Lantern’s earnings before financing costs go to its lenders and landlords. Net debt to EBITDA rises from 1.12 to 2.51. The unadjusted figures are not wrong, but they leave out a five-year commitment that is as fixed as a loan’s.

One detail of the adjustment matters for comparisons. It keeps ASC 842’s amortisation figure ($28,876), which early in a lease is below straight-line depreciation of the right-of-use asset, because the liability’s interest is highest at the start. Under IFRS 16 the same café would depreciate the asset straight-line, $202{,}255 \div 60 \times 10 = 33{,}709$ for ten months, so its EBIT would be about $39,078 and its interest coverage 2.79 rather than 3.14. EBITDA, $92,587, is the same either way, because both depreciation and interest are added back.

When equity is negative

Equity is a residual: assets minus liabilities. When a company pays its owners more, over the years, than it earns, or makes large losses, equity can fall below zero, and the company reports a shareholders’ deficit. Starbucks is the best-known example among large companies.

EBITDA uses the cash-flow statement’s total depreciation and amortisation, 1,592.4, rather than the income statement line, 1,512.6, which excludes amounts recorded within other cost lines. Starbucks’ operating income includes 301.2 of income from equity investees. Source: Form 10-K for the fiscal year ended 29 September 2024.

A debt-to-equity ratio of −2.09 does not mean Starbucks has negative leverage; it means the ratio has stopped working. As equity approaches zero, debt ÷ equity and the equity multiplier rise without limit, and debt to capital climbs past 100% (Starbucks’ is 191.6%); when equity crosses zero the first two flip sign and any comparison breaks. Return on equity fails the same way. With negative equity, use measures that don’t divide by it: debt ratio, debt to EBITDA and coverage. By those, Starbucks covers its interest 9.62 times and its net debt is 1.72 times EBITDA: a company with heavy obligations that its earnings carry comfortably.

Where the deficit came from matters too. Starbucks already had a shareholders’ deficit of $5,314.5 million at the start of fiscal 2022. Over fiscal 2022 to 2024 it paid $7,280.1 million in dividends and $6,264.1 million to repurchase its own shares, $13,544.2 million in all, against net earnings attributable to Starbucks of $11,167.0 million: $2,377.2 million more than it earned. Paying out more than it earned, financed partly by borrowing, is a choice about capital structure, not a sign of losses. A small business with negative equity from accumulated losses is a very different case, and the debt ratio alone won’t tell them apart: read the statement of changes in equity.

For comparison, Harbourline Roasters, the fictional roaster from F00, has a debt ratio of 54.5%, debt to equity of 0.70, interest coverage of 5.55 and net debt of 1.77 times EBITDA, close to Lantern’s 2026 leverage but with much weaker coverage.