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Fundamental Credit Analysis

One-line definition

The qualitative and ratio-based work of deciding whether a borrower can actually service its debt — the layer underneath spread, Z-spread, and default-probability math that decides which bonds a credit PM wants to own in the first place.

Formula

leverage_ratio = total_debt / EBITDA (lower is safer; often a covenant's maximum)

interest_coverage_ratio = EBITDA / interest_expense (higher is safer; often a covenant's minimum)

fixed_charge_coverage_ratio = EBITDA / (interest_expense + mandatory_principal_payments) — stricter than interest coverage, since scheduled amortization has to be paid in cash too, not just refinanced indefinitely.

Why PMs care

Everything else this repo's credit modules compute — spread duration, Z-spread, default and recovery — takes a spread or a default probability as given. Fundamental analysis is how a credit analyst actually forms that view: is this issuer's leverage deteriorating, does it generate enough EBITDA to cover its interest and scheduled principal, and what happens to the bondholder if it doesn't.

Covenants

Covenants are the contractual triggers tied to these same ratios. Incurrence covenants (typical in public high-yield bonds) are only tested when the issuer takes a specific action — "you may not issue more senior debt if leverage would exceed 4.0x after the issuance." Maintenance covenants (typical in bank loans and leveraged finance) are tested periodically regardless of any action — "leverage must stay below 4.0x at every quarterly reporting date." Maintenance covenants give lenders an earlier warning and more leverage to force a renegotiation before things get worse; their absence ("covenant-lite") is exactly what let leveraged loans converge toward high-yield-bond-style protections over the 2010s (see leveraged loans).

Rating agencies

S&P, Moody's, and Fitch each publish their own ratings methodology, but all three build on the same core inputs this page covers: leverage, coverage, and cash-flow-based measures (e.g. FFO/Debt), adjusted issuer-by-issuer for industry, business-risk, and structural factors a pure ratio calculation misses. A rating downgrade is frequently the market-moving event even when the underlying ratios only moved gradually — see credit migration for the portfolio-risk side of that.

Common mistakes

  • treating EBITDA as a cash-flow measure — it ignores working-capital changes, capex, and taxes, all of which can leave a "well-covered" borrower on paper without enough actual cash to pay its bills
  • comparing leverage ratios across industries without adjusting — an asset-heavy, stable-cash-flow business (utilities) can safely carry leverage that would be dangerous for a cyclical, capex-light one
  • reading a single quarter's ratio in isolation instead of the trend — deteriorating coverage over several quarters is a much stronger signal than one weak print

Limitations

leverage_ratio, interest_coverage_ratio, and fixed_charge_coverage_ratio are pure ratio calculations from inputs you supply — this repo doesn't parse financial statements or forecast EBITDA. Real credit work spends most of its effort on exactly that: building and stress-testing the EBITDA/debt projections that go into these formulas.

Free resources