Credit ratings and leverage ratios
6 min read · updated July 8, 2026
When a company borrows money, a lender has one question above all others: will I get paid back? A credit rating is a shorthand answer to that question. It is a letter grade, handed out by an independent agency, that scores how likely a borrower is to repay its debt on time and in full. The higher the grade, the safer the borrower looks, and the cheaper it can borrow.
Three agencies dominate: S&P, Moody's, and Fitch. They each rate the same borrower on their own scale, though the scales line up almost one to one. S&P and Fitch use letters like AAA and BBB. Moody's uses a slightly different notation like Aaa and Baa. When bankers talk about a company's rating, they usually mean the grade from one or more of these three.
The rating scale, top to bottom
The scale runs from the safest borrowers at the top down to companies already in default at the bottom. The categories below use S&P and Fitch notation on the left and the matching Moody's notation in the middle. The right column marks the two zones every banker cares about, investment grade and high yield.
| S&P / Fitch | Moody's | Zone |
|---|---|---|
| AAA | Aaa | Investment grade |
| AA | Aa | Investment grade |
| A | A | Investment grade |
| BBB | Baa | Investment grade |
| BB | Ba | High yield |
| B | B | High yield |
| CCC | Caa | High yield |
| CC to C | Ca to C | High yield |
| D | D | Default |
Within each letter band the agencies add a plus or minus (or a number for Moody's) to fine-tune the grade, so you get AA+, AA, AA-, and so on. A D, or a C on the Moody's scale, means the borrower has already missed payments.
Investment grade versus junk
The single most important line on that whole scale sits between BBB and BB. Everything at BBB- (Baa3 on the Moody's scale) and above is investment grade: the borrower is considered solid and reasonably safe. Everything below that line, BB+ (Ba1) and down, is high yield, more bluntly called "junk."
The exact cutoff is BBB-/Baa3. At or above it, a company is investment grade. One notch lower, at BB+/Ba1, it is high yield. That single step does not look like much on the page, but it changes who is even allowed to lend to the company. Many large investors, such as pension funds and insurers, are restricted to investment grade only, so falling below the line shrinks the pool of buyers for a company's debt and pushes its borrowing cost up sharply.
Why a rating matters: it sets the cost of debt
A rating is not a trophy. It is a price tag. The grade sets a company's cost of debt, the interest rate it has to pay to borrow. A AAA borrower is treated as almost certain to repay, so lenders accept a low rate. A B borrower might not make it, so lenders demand a fat interest rate to compensate for the risk. Same dollar borrowed, very different cost, entirely because of the rating.
Leverage: turns and "5x levered"
So what actually drives the rating? The biggest single factor is how much debt the company carries relative to its earnings. The standard measure is the leverage ratio, total debt divided by EBITDA, a rough proxy for annual cash profit.
Here Debt is the company's total borrowings and EBITDA is its yearly operating cash profit. A company with $500 million of debt and $100 million of EBITDA is at $500 divided by $100, or 5.0x. Bankers call each unit a "turn" of leverage, so this company is "5x levered" or "carrying five turns." Investment grade companies usually sit around 1x to 3x. A leveraged buyout might push a company to 5x, 6x, or higher, which is exactly why buyout targets often carry a junk rating.
Coverage: can it actually pay the interest?
Leverage tells you how big the debt is. Coverage tells you whether the company can afford it. A coverage ratio compares earnings to the interest bill.
A company with $100 million of EBITDA and $20 million of annual interest has coverage of 5.0x, meaning its cash profit covers its interest five times over. A stricter version subtracts capital spending first, because money spent keeping the machines running is not available to pay lenders. If that same company spends $20 million on capex, its (EBITDA minus capex) over interest is $80 divided by $20, or 4.0x. Higher coverage means more cushion, and agencies reward it with a better rating.
Treating leverage and coverage as the same thing. They answer different questions. Leverage (Debt/EBITDA) measures how big the debt pile is. Coverage (EBITDA/Interest) measures whether current earnings can service that debt. A company can look fine on one and dangerous on the other. Load on more debt and leverage rises while coverage falls, the rating drops, and the interest rate the company pays climbs. That is the whole feedback loop that ratings capture.
Covenants: the lender's tripwires
Lenders back up the rating with covenants, rules written into the loan that the borrower must follow. Maintenance covenants test a ratio every quarter, for example a cap on leverage or a floor under coverage, and breaking one is a default even if no payment was ever missed. Incurrence covenants only bite when the company does something specific, like raising new debt or paying a dividend. Both exist to stop a borrower from quietly getting riskier after the loan is made.
Know the BBB-/Baa3 cutoff cold and be able to compute both ratios in your head. If told a company has $600 million of debt and $150 million of EBITDA, answer "4x levered" instantly. Then connect the dots out loud: more leverage lowers the rating, a lower rating raises the cost of debt, and a higher cost of debt eats the cash flow that would otherwise pay the debt down. Saying that chain in one clean breath shows you understand why ratings matter, not just what the letters are.
Glossary
New to the lingo? Every term used above, in plain English.
- Credit rating
- A grade from an agency (like S&P or Moody's) on how likely a borrower is to repay. Investment grade is safer; below that is high yield, and lower ratings mean higher borrowing costs.
- Investment grade
- The safer tier of credit ratings, BBB-/Baa3 and above, where a borrower is considered reasonably likely to repay. Anything below that cutoff is high yield, or junk, and pays a higher interest rate.
- High-yield bond
- A bond from a company with a lower credit rating (below investment grade). It pays more interest to compensate lenders for the higher risk of default.
- Cost of debt
- The rate a company pays to borrow. Because interest is tax-deductible, the after-tax cost of debt is what goes into WACC, and it is cheaper than equity.
- Leverage ratio
- How much debt a company carries relative to its earnings, usually measured as debt divided by EBITDA. Higher leverage means more risk and more required debt paydown.
- Coverage ratio
- A measure of whether a company’s earnings can afford its interest bill, usually EBITDA divided by interest. A stricter version subtracts capex first, since that cash is not available to pay lenders. Higher coverage means more cushion.
- EBITDA
- Earnings Before Interest, Taxes, Depreciation, and Amortization. A rough proxy for a company’s operating cash profit, before financing and accounting choices.
- CapEx (Capital Expenditures)
- Cash a company spends to buy or upgrade long-lived assets like equipment, factories, or technology. It is an investment in the business, not a day-to-day expense.
- Covenant
- A rule in a loan agreement the borrower must follow, like keeping debt below a set multiple of EBITDA. Breaking one can let lenders demand repayment.
- LBO (Leveraged Buyout)
- Buying a company using mostly borrowed money, then using the company’s own cash flow to pay that debt down over time. The classic private equity playbook.
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