Debt-to-EBITDA Ratio (Debt/EBITDA Ratio)
What Is the Debt-to-EBITDA Ratio?
Debt/EBITDA — earnings before interest, taxes, depreciation, and amortization — is a ratio measuring the amount of income produced and available to pay down debt before covering interest, taxes, depreciation, and amortization expenses. Debt/EBITDA measures a company's ability to pay off its incurred debt. A high ratio result could demonstrate a company has a too-weighty debt load.
Banks frequently incorporate a certain debt/EBITDA target in the pledges for business loans, and a company must keep up with this settled upon level or risk having the whole loan become due right away. This measurement is generally utilized by credit rating agencies to evaluate a company's probability of defaulting on issued debt, and firms with a high debt/EBITDA ratio will most likely be unable to service their debt in a proper way, leading to a brought down credit rating.
Formula and Calculation
where:
Debt = Long-term and short-term debt obligations
EBITDA = Earnings before interest, taxes, depreciation, and amortization
To determine the debt/EBITDA ratio, add the company's long-term and short-term debt obligations. You can find these numbers in the company's quarterly and annual financial statements. Partition this by the company's EBITDA. You can compute EBITDA utilizing data from the company's income statement. The standard method to compute EBITDA is to begin with operating profit, likewise called earnings before interest and taxes (EBIT), and afterward add back depreciation and amortization.
The debt/EBITDA ratio is like the net debt/EBITDA ratio. The principal difference is the net debt/EBITDA ratio deducts endlessly cash equivalents while the standard ratio doesn't.
Everything the Ratio Can Say to You
The debt/EBITDA ratio compares a company's total obligations, including debt and different liabilities, to the genuine cash the company gets and uncovers how capable the firm is of paying its debt and different liabilities.
At the point when lenders and analysts take a gander at a company's debt/EBITDA ratio, they need to realize how well the firm can cover its debts. EBITDA addresses a company's earnings or income, and it's an abbreviation for earnings before interest, taxes, depreciation, and amortization. It's calculated by adding back interest, taxes, depreciation, and amortization expenses to net income.
Analysts frequently view at EBITDA as a more accurate measure of earnings from the firm's operations, as opposed to net income. A few analysts see interest, taxes, depreciation, and amortization as an obstruction to real cash flows. All in all, they see EBITDA as a cleaner representation of the real cash flows available to pay off debt.
Limitations of the Ratio
Analysts like the debt/EBITDA ratio since it is not difficult to compute. Debt can be found on the balance sheet and EBITDA can be calculated from the income statement. The issue, nonetheless, is that it may not give the most reliable measure of earnings. More than earnings, analysts need to check the amount of genuine cash available for debt repayment.
Depreciation and amortization are non-cash expenses that don't really impact cash flows, however interest on debt can be a massive expense for certain companies. Banks and investors taking a gander at the current debt/EBITDA ratio to gain understanding on how well the company can pay for its debt might need to think about the impact of interest on debt-repayment ability, even on the off chance that that debt will be remembered for new issuance. Thus, net income minus capital expenditures, plus depreciation and amortization might be the better measure of cash available for debt repayment.
Illustration of Debt-To-EBITDA Use
For instance, if company A has $100 million in debt and $10 million in EBITDA, the debt/EBITDA ratio is 10. Assuming company A pays off half of that debt in the next five years, while expanding EBITDA to $25 million, the debt/EBITDA ratio tumbles to two.
A declining debt/EBITDA ratio is better than a rising one since it suggests the company is paying off its debt as well as developing earnings. Similarly, a rising debt/EBITDA ratio means the company is expanding debt more than earnings.
A few industries are more capital intensive than others, so a company's debt/EBITDA ratio ought to just be compared to similar ratio for different companies in a similar industry. In certain industries, a debt/EBITDA of 10 could be totally normal, while in different industries a ratio of three to four is more fitting.
Highlights
- A debt/EBITDA ratio that declines after some time shows a company that is paying down debt or expanding its earnings or both.
- The ratio shows how much genuine cash flow the company has available to cover its debt and different liabilities.
- The debt/EBITDA ratio is utilized by lenders, valuation analysts, and investors to check a company's liquidity position and financial wellbeing.
