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CORPORATES

NOVEMBER 20, 2014

SPECIAL COMMENT

Leveraged Finance

EBITDA: Used and Abused

As a widely used fundamental measure for assessing corporate profitability, value
and risk, consistency is important

Table of Contents:
RISK TOLERANCE IS ON THE RISE
GETTING EBITDA RIGHT IS
IMPORTANT
CALCULATING EBITDA CAN BE OPEN
TO INTERPRETATION
EBITDA – WITH OTHER METRICS – CAN
HELP SIGNAL DEFAULTS
MOODY’S RELATED RESEARCH

2
4
5
6
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Analyst Contacts:
NEW YORK

+1.212.553.1653

Christina Padgett
+1.212.553.4164
Senior Vice President
christina.padgett@moodys.com
John E. Puchalla, CFA
+1.212. 553.4026
Senior Vice President
john.puchalla@moodys.com
Jason Cuomo
+1.212.553.4026
Vice President - Senior Accounting Analyst
jason.cuomo@moodys.com
Tom Marshella
+1.212.553.7795
Managing Director - US and America
Corporate Finance
tom.marshella@moodys.com

» Risk tolerance is on the rise. Investor thirst for yield in the current low-rate environment
is driving an issuer friendly market. Increasing low-rated debt issuance and declining
covenant quality is prompting regulators to review underwriting standards more closely
alongside growing concern from market participants. In Moody’s view, an accurate picture
of a firm’s creditworthiness requires scrutiny of key metrics like EBITDA – a fundamental
measure for assessing a company’s profitability and credit profile.
» Getting EBITDA right is important. We view EBITDA as an important metric in credit
analysis: it is present in most nonfinancial corporate industry methodologies, generally in
ratios that are indicators for leverage. We standardize our EBITDA calculation for nonfinancial corporations to facilitate consistency and cross-sector comparability. Other
market participants may have alternative approaches and therefore calculate EBITDA
differently. In this report, we reflect on the strengths of EBITDA and its limitations as an
indicator of credit risk.
» Calculating EBITDA can be open to interpretation. Market participants use EBITDA as
a proxy for normalized pre-tax unlevered operating earnings. But what constitutes
“normal” is subjective, and in periods of low risk tolerance, issuers can have a tendency to
more aggressively calculate EBITDA to improve their credit metrics and facilitate market
access. No single credit measure is sufficient by itself as an indicator for impending credit
stress. In addition to standardizing our EBITDA calculation, we use a number of financial
ratios, including measures of cash flow from operations and free cash flow when we make a
comprehensive assessment of credit quality.
» EBITDA – with other metrics – can help signal defaults. EBITDA measures, along with
other credit ratios and liquidity indicators, often provide clear signals of rising default risk.
An examination of three different EBITDA-based interest coverage ratios for companies
that defaulted in 2009 and 2013 shows that declines in these ratios signaled credit stress
during the three years leading up to default.

CORPORATES

Risk tolerance is on the rise
A significant increase in the number of low-rated debt-financed deals across industries amid record
speculative-grade issuance indicates that risk tolerance is on the rise (Exhibit 1) as investors search for
yield in a low-interest rate environment. This year’s sharp rise in debt-funded M&A activity is also
supplanting less risky refinancing as the primary driver of speculative-grade issuance. Covenant
protection is also declining, with our loan and bond covenant quality indexes continuing to show
deterioration this year (Exhibit 2). The number of covenant-lite loans 1 has also increased dramatically
– from just 3% of total institutional loans in 2010 to roughly 70% of issuance today. 2
EXHIBIT 1

The Number of Lower-Rated New Speculative-Grade Issuers Is Increasing
North American New Issuer Corporate Family Ratings
B1%

B2%

B3%

90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
2006

2007

2008

2009

2010

2011

2012

2013

2014 YTD

Data as of 1 October 2014
Source: Moody’s Investors Service

EXHIBIT 2

Covenant Quality Is Also Declining Based on Moody’s Covenant Quality Indices
Covenant Quality Index - 3 Month Rolling Average

3-Month Rolling Spread to Benchmark

3.3

700

3.4

650

3.5

600

3.6
3.7

550

3.8

500

3.9

450

4

400

4.1

350
300

Mar-11
Apr-11
May-11
Jun-11
Jul-11
Aug-11
Sep-11
Oct-11
Nov-11
Dec-11
Jan-12
Feb-12
Mar-12
Apr-12
May-12
Jun-12
Jul-12
Aug-12
Sep-12
Oct-12
Nov-12
Dec-12
Jan-13
Feb-13
Mar-13
Apr-13
May-13
Jun-13
Jul-13
Aug-13
Sep-13
Oct-13
Nov-13
Dec-13
Jan-14
Feb-14
Mar-14
Apr-14
May-14
Jun-14
Jul-14
Aug-14
Sep-14

This publication does not announce
a credit rating action. For any credit
ratings referenced in this
publication, please see the ratings
tab on the issuer/entity page on
www.moodys.com for the most
updated credit rating action
information and rating history.

4.2
4.3

Source: Moody’s High-Yield Covenant Database

Note: Moody’s Covenant Quality Index (CQI) tracks the degree of overall investor protection in the covenant packages of highyield bonds issued in the US and Canada on a three-month rolling average basis.

1

See Time Is Catching Up with Covenant-Lite, 24 June 2014

2

Data source is Thompson Reuters

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NOVEMBER 20, 2014

SPECIAL COMMENT: LEVERAGED FINANCE: EBITDA: USED AND ABUSED

CORPORATES

All of this comes at a time when leverage levels have been rising (Exhibit 3) and regulators have been
tracking risk more closely. In a 7 November joint announcement by the US Federal Reserve, the
FDIC and the OCC, the regulators said the annual Shared National Credits (SNC) review found that
in 2014 the volume of criticized assets 3 was at $340.8 billion, or 10% of total commitments, which is
roughly double pre-crisis levels and follows three consecutive years of improvements. In July this year,
during the Fed’s semi-annual testimony to the Senate Banking Committee, Fed Chair Janet Yellen
warned of deterioration in lending standards and of risks that could develop in this low-interest rate
environment.
EXHIBIT 3

Leverage Levels Have Been Rising for Speculative-Grade Companies
Median Debt/EBITDA for issuers at Ba1 and below
5.10x

5.06x

5.11x

4.91x

4.69x

4.66x
4.51x

2007

4.51x

2008

2009

2010

2011

2012

2013

2014 Q2

Source: Moody’s Financial Metrics

Regulators flagged similar concerns in the March 2013 Interagency Guidance on Leveraged Lending
(LLG), where they cautioned about corporate transactions that push leverage above 6x total
debt/EBITDA for most industries.
The inclusion of a specific EBITDA-based metric (earnings before interest, taxes, depreciation and
amortization) raises important questions about how EBITDA is being calculated. Regulators were not
specific on this point. This is not a new question – but it is coming back into focus as lenders weigh
the potential for fresh constraints on their ability to assume risk. To understand why EBITDA matters,
it is important to start with an understanding of what EBITDA is, the role it serves and, ultimately,
how best to use it.
Given the frothy credit environment, we think this is an important time to revisit both the merits and
shortcomings of EBITDA. In this report, we reflect on the strengths of EBITDA and its limitations as
an indicator of credit risk. Our sensitivity is heightened during times where demand is particularly
favorable for issuers.

3

3

A criticized asset is rated special mention, substandard, doubtful, or loss as defined by the agencies' uniform loan classification standards. According to the report, the
2014 review included an evaluation of underwriting standards on SNCs that were originated in 2013.

NOVEMBER 20, 2014

SPECIAL COMMENT: LEVERAGED FINANCE: EBITDA: USED AND ABUSED

CORPORATES

Getting EBITDA right is important
We view EBITDA as a useful metric that is broadly incorporated in most credit assessments. But we
are also aware that EBITDA is not calculated uniformly by issuers, investors and in credit agreements
and bond indentures. As demand remains strong for issuers with weak balance sheets and companies
are able to negotiate myriad aggressive adjustments to EBITDA in indenture and credit agreement
financial covenants, understanding the limitations of EBITDA is once again important.
EBITDA is present in most corporate industry methodologies, generally in respect to ratios that are
indicators for leverage across rating levels. The general relationship between leverage and rating varies
by sector due to differences in industry risks, which include cyclical volatility. We standardize our
EBITDA calculation for non-financial corporations to facilitate consistency and cross-sector
comparability.
Other market participants may calculate EBITDA differently, based on how they wish to portray
leverage levels. Exhibit 4 illustrates how EBITDA can diverge before and after factoring in unusual,
non-recurring and other standard adjustments. The gap is wider when restructurings and write-downs
intensify, as happened during the last recession. This chart shows data for approximately 1,200 public
and private speculative- grade companies.
EXHIBIT 4

EBITDA Measure Can Look Significantly Different with Adjustments
(US speculative-grade Issuers’ EBITDA before and after Moody’s adjustments)
Difference

Reported

Moody's Adjusted

Median EBITDA ($ thousands)

180,000
160,000
140,000
120,000
100,000
80,000
60,000
40,000
20,000
0
2009

2010

2011

2012

2013

Reported EBITDA is Earnings (revenues less expenses) Before Interest, Taxes, Depreciation, and Amortization and is typically used as a proxy for pretax unlevered operating earnings. Moody’s EBITDA incorporates our effort to standardize EBITDA for peer comparability by incorporating adjustments
for pension, leases, unusual expenses or gains, and other items. See Appendix and “Moody’s Approach to Global Standard Adjustments in the Analysis
of Financial Statements for Non-Financial Corporations: Standardized Adjustments to Improve Global Consistency,” Moody’s Investors Service,
December 2010
Source: Moody’s Investors Service

The difference between reported and Moody’s EBITDA is a function of adjustments we make for items
that are typical in most financial statements – pension and leases being the most significant – as well as
adjustments for unusual and non-recurring items and other “non-standard” items that analysts feel are
appropriate. Companies and industries with significant rent or pension obligations, such as retail and
transportation, are likely to have higher Moody’s than reported EBITDA because our standard
adjustments (for both leases and pensions 4) typically add to reported EBITDA by reclassifying a portion
of expenses to interest and depreciation. Our pension and lease adjustments also increase debt.
4

4

We adjust financial statements for the difference between service cost and reported pension expense. While there are nuances, our pension adjustment generally reduces
operating expenses and increases EBITDA if reported pension expense exceeds service cost, and increases operating expenses and reduces EBITDA if service cost exceeds
reported pension expense.

NOVEMBER 20, 2014

SPECIAL COMMENT: LEVERAGED FINANCE: EBITDA: USED AND ABUSED

CORPORATES

Depending on leverage and the magnitude of an issuer’s pension and operating leases, our adjustments
can be neutral to or reduce leverage; however, more often than not the adjustment increases leverage.
Significant judgment is employed when we make adjustments for unusual and non-recurring items
and other analytical non-standard adjustments, but we also consider a well-defined framework of
factors. These include the duration, frequency, timing, materiality, substance, classification and nature
of the underlying activity.

Calculating EBITDA can be open to interpretation
Market participants use EBITDA as a proxy for normalized pre-tax unlevered operating earnings. But
what constitutes “normal” is subjective, and we find that in periods of low risk tolerance, issuers more
aggressively calculate EBITDA to improve their credit metrics and facilitate market access.
EBITDA has long been viewed by market participants as a near-cash proxy for “normalized” operating
earnings, before the burdens of capital expenditures, interest and taxes and the “noise” created by
swings in working capital. This gives it broad appeal among sponsors, investors and analysts for
estimating the future operating results of a company, calculating enterprise value and comparing
financial performance among companies. The two most commonly seen EBITDA-based credit ratios,
interest coverage (EBITDA/interest expense) and leverage (debt/EBITDA), are used in equity and
credit analysis, including financial maintenance tests and incurrence covenants in both credit
agreements and bond indentures.
However, EBITDA may be calculated aggressively to portray a more favorable credit profile.
Investors may take a more conservative view than the company. Even when there is agreement on the
calculation, EBITDA does not capture key items such as interest, taxes, working capital and capital
expenditures that affect a company’s cash flow. It is essential to understand how these differences can
affect a company’s credit profile. The desire of banks and market participants for additional clarity on
EBITDA-based measures used by regulators in the LLG highlights the tension inherent in subjective
indicators such as EBITDA.
Reasonable differences of opinion can exist regarding whether certain charges such as restructuring
expenses are “normal” or ‘non-recurring.” EBITDA definitions in bond indentures and credit
agreements are usually quite detailed, but the amount of “add-backs” varies widely from company to
company, which diminishes comparability. The type of adjustments also vary widely; they range from
reasonable add-backs of expenses recorded over the prior 12-month period that obscure underlying
operating trends such as non-cash impairment charges or gains/losses on asset sales.
Other add-backs are more aggressive, such as restructuring charges for a company at which costreduction initiatives are ongoing or the addition of “pro forma” cost savings that depend on expenses
being reduced in the future. Such savings are beneficial but do not always result in a future dollar-fordollar EBITDA increase because they may not be fully realized and any savings achieved may get eaten
up by cost increases, business reinvestment or price reductions due to competitive pressure. Projected
cost savings can also be overestimated. Higher earnings and better covenant ratios in current periods,
produced by incorporating projected future, synergies can mask potential covenant compliance issues
if future results are worse-than-management expected.

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SPECIAL COMMENT: LEVERAGED FINANCE: EBITDA: USED AND ABUSED

CORPORATES

EBITDA’s limitations can vary greatly depending on the company, circumstance or industry.
EBITDA requires estimates of income earned and costs incurred, but the amount and/or timing of
actual cash flows typically differs from these estimates – making working capital analysis important.
It is essential to assess how issuers calculate EBITDA in bond indentures and credit agreements
because it is typically used in financial maintenance, restricted payment, debt incurrence, and other
covenants. Such covenants affect a company’s liquidity, debt capacity and use of cash flow. However,
there are limitations in the effectiveness of any credit ratio in predicting default and loss, including
EBITDA-based ratios. As well as standardizing our EBITDA calculation to improve comparability, we
use many other indicators when evaluating credit risk, including EBIT and various measures of cash
flow and free cash flow and liquidity as part of our comprehensive assessment of credit quality.

EBITDA – with other metrics – can help signal defaults
In most industry sectors, EBITDA-based metrics are a valuable tool for assessing a company’s
financial risks and flagging financial distress in advance of default. In Exhibits 5 and 6 (page 7) we
depict various interest coverage ratios over the three-year period leading up to US non-financial
corporate defaults in 2013 and during the most recent downturn (using the representative peak default
year of 2009).
Median ratios for EBITDA/interest, EBIT/interest and (EBITDA-capex)/interest all deteriorated over
the three-year period prior to default. The first two ratios declined by a greater proportion, which is
not surprising since struggling companies often constrain capital expenditures to conserve cash.
However, the trend for all three ratios was predictive despite differences in broad credit stress in 2009
and 2013. Credit conditions in the US were deteriorating in 2008 and generally improving in 2013.
This difference is reflected in the much steeper decline in ratios in the 2006-2008 period compared to
the 2010-2012 period. The key common point is that these EBITDA measures were significantly
declining before default in both periods.
The exhibits are based on defaulting US company counts of 100 in 2009 (representing $113 billion of
rated debt) and 13 in 2013 (covering $7.6 billion of rated debt). The data are subsets of the total
number of 158 and 27 rated entity defaults in 2009 and 2013, respectively. The difference is due to
the removal of duplicate rated entities within the same issuer family (for which there is only one set of
financial statements), companies which changed their fiscal year or for whom we did not have financial
statements for the full three-year period leading up to default. We also excluded companies whose
interest coverage deterioration over the three year period prior to default is magnified because of a
significant change in the company debt structure, such as would occur after an LBO. To be sure,
interest coverage for such companies also deteriorated and including them in the data set would
steepen the slope of the declines in both exhibits.

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SPECIAL COMMENT: LEVERAGED FINANCE: EBITDA: USED AND ABUSED

CORPORATES

EXHIBIT 5

Interest Coverage Trends for 2013 US Non-Financial Corporate Defaulters
EBITDA/ Interest

EBITDA-CapEx/ Interest

EBIT/ Interest

2.0x
1.8x
1.6x
1.4x
1.2x
1.0x
0.8x
0.6x
0.4x
0.2x
0.0x
2010

2011

2012

Median data for 2013 US Corporate defaulters; incorporates Moody's standard adjustments.
Based on 13 defaulting issuers. This is a subset of the 27 rated entity defaults in 2013 because we removed duplicate rated entities within the same
issuer family (for which there is only one set of financial statements), companies where we did not have the prior three years of financial statements,
companies which changed their fiscal years during the 2010-2012 time period, and companies where trend data over the 2010-2012 period is less
meaningful because of a change in the company circumstances such as LBO
Source: Moody’s Investor Services
EXHIBIT 6

Interest Coverage Trends for 2009 US Non-Financial Corporate Defaulters
EBITDA/ Interest

EBITDA-CapEx/ Interest

EBIT/ Interest

2.5x

2.0x

1.5x

1.0x

0.5x

0.0x
2006

2007

2008

Median data for 2009 US Corporate defaulters; incorporates Moody's standard adjustments.
Based on 100 defaulting issuers. This is a subset of the 158 rated entity defaults in 2009 because we removed duplicate rated entities within the same
issuer family (for which there is only one set of financial statements), companies where we did not have the prior three years of financial statements,
companies who changed their fiscal years during the 2006-2008 time period, and companies where trend data over the 2006-2008 period is less
meaningful because of a change in the company circumstances such as LBO.
Source: Moody’s Investor Services

In the three years leading up to the default, the median interest coverage ratios for the defaulting
issuers in 2009 and 2013 were considerably worse than for all single-B rated issuers (Exhibit 7, page 8).
The interest coverage deterioration for the 2009 defaulting issuers was more pronounced than for the
2013 defaulters because of the sudden drop in corporate earnings as the recession took hold.

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SPECIAL COMMENT: LEVERAGED FINANCE: EBITDA: USED AND ABUSED

CORPORATES

EXHIBIT 7

Defaulting Issuers Had Considerably Worse Median Interest Coverage
2009 defaulters

Medians (single-B)

2006

2007

2008

2006

2007

2008

EBITDA/ Interest

2.2

1.7

1.2

2.3

2.3

2.3

EBITDA-CapEx/ Interest

1.2

0.9

0.8

1.3

1.3

1.3

EBIT/ Interest

1.0

0.7

0.4

1.3

1.3

1.2

2013 defaulters
2010

2011

Medians (single-B)
2012

2010

2011

2012

EBITDA/ Interest

1.8

1.7

1.5

2.7

2.7

2.5

EBITDA-CapEx/ Interest

1.1

1.0

0.9

1.7

1.6

1.5

EBIT/ Interest

0.7

0.7

0.5

1.4

1.4

1.3

Ratios incorporate Moody's adjustments.
Non-financial corporates (public and private), excluding GRIs, regulated utilities that deliver electricity and gas, power and water, companies,
exploration and production companies, project finance, airports, toll roads, investment holding companies, real estate investment trusts and
homebuilders
Source: Moody’s Investor Services

Increasing leverage (debt-to-EBITDA) provides a useful indication of deterioration in value, but
coverage of interest expense is likely to best explain a near-term default. Given the cov-lite status of
many new issuers, default risk is more likely to be associated with an inability to service debt and fund
day-to-day operations, as opposed to the early signal provided by covenant violations. However, an
unsustainable capital structure could also signal the potential for a distressed exchange. Distressed
exchanges have become a more common type of default since the financial crisis and are easier to
execute when an issuer has a cov-lite structure.
The current spate of issuers with highly adjusted EBITDA will require a more disciplined approach to
credit analysis. EBITDA cannot be taken at face value and generally should be evaluated alongside
other liquidity and cash metrics. Overly optimistic adjustments, pro forma for “future synergies,”
future earnings” or “run-rate EBITDA” will leave investors vulnerable to the next credit default cycle
downturn.

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SPECIAL COMMENT: LEVERAGED FINANCE: EBITDA: USED AND ABUSED

CORPORATES

Moody’s Related Research
Special Comments:

»

Putting EBITDA In Perspective: Ten Critical Failings Of EBITDA As The Principal
Determinant of Cash Flow”, June 2000 (55730)

»

High-Yield Bond Covenants Arcane EBITDA Adjustments Can Loosen Covenant Protection,
November 2012 (145986)

»

Putting EBITDA In Perspective, June 2000 (55730)

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of
this report and that more recent reports may be available. All research may not be available to all clients.

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SPECIAL COMMENT: LEVERAGED FINANCE: EBITDA: USED AND ABUSED

CORPORATES

Report Number: 173806

Authors
Christina Padgett
John Puchalla

Production Specialist
Cassina Brooks

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SPECIAL COMMENT: LEVERAGED FINANCE: EBITDA: USED AND ABUSED