The debt-to-EBITDA ratio is a comparison of financial debt to earnings before interest, taxes, depreciation and amortization. This is a very common ratio used to estimate business valuations. It is a good determinant of a company's financial health and liquidity position. It is a measure of a company's ability to pay its debts. It compares a company's financial obligations, including debt and other liabilities, with its actual cash earnings excluding non-cash expenses.
The debt/EBITDA ratio can be used to compare a company's liquidity position with that of another company in the same industry. A lower debt/EBITDA ratio is a positive indicator that the company has sufficient funds to meet its financial obligations as they come due. A higher debt/EBITDA ratio indicates that the company is highly leveraged and may have difficulty repaying its debt.
Debt/EBITDA is one of the most common metrics used by creditors and rating agencies to assess the probability of default on an issued debt. In simple words, it is a method used to quantify and analyze the ability of a company to repay its debts. This ratio provides the investor with the approximate period of time required by a company or business to pay off all its debts, ignoring factors such as interest, depreciation, taxes and amortization.
A high debt-to-equity ratio could result in a lower credit rating for the company. Conversely, a lower ratio indicates the company's willingness to take on more debt if necessary, thus warning of a comparatively high credit rating.
The ratio is calculated by dividing a company's total debt by its Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA):
Debt/EBITDA ratio = Liabilities / EBITDA
The debts used in this calculation include all of the company's outstanding debt obligations, including long-term debt, short-term debt, and any other liabilities that must be paid back over time.
The main target of this ratio is to reflect the cash available with the company to pay back its debts, and not how much income is being earned by the firm.
Theoretically, it is possible for the debt/EBITDA ratio to be negative, but in practice this is highly unlikely. This would occur if a company had negative debt, which would mean that the company had more assets than liabilities. This is unlikely for most companies, as most companies have some level of debt.
EBITDA can also be negative in some cases, which occurs when a company's operating costs exceed its revenues. In such scenario, the company is operating at a loss and the ratio would be negative.
Norms and Limits
The debt/EBITDA ratio is popular with financial analysts because it relates a company's debt to its cash flows by ignoring non-cash expenses. Ultimately, it is cash flows (as opposed to profits) that are used to pay down debt. Companies in normal financial condition have a debt-to-EBITDA ratio of less than 3. Ratios above 4 or 5 usually raise alarm bells because they indicate that a company is likely to have difficulty managing its debt burden and is therefore less likely to be able to obtain additional credit needed to grow and expand the business.
The debt/EBITDA ratio is usually not suitable for comparing companies in different industries. Other industries have different capital requirements. Companies in different industries have different capital structures. Some industries are capital intensive and require larger amounts of debt to finance their operations. Therefore, the debt/EBITDA ratio may not provide reliable conclusions when comparing different industries.
Usage of Debt/EBITDA Ratio
This ratio is helpful in management decisions and can be used by a company interested in investing in a takeover bid. In addition, the ratio is also helpful to the potential buyer in estimating the profitability of the company without the aggressive spending of the current manager. In this case, if the company does not spend much on purchasing new equipment or opening new stores, it will have lower depreciation and amortization costs, thus making the company profitable without considering these extra costs.
However, it is a risky process to use the debt/EBITDA ratio to analyze a company's ability to repay debt. A company can spend a huge amount of money on new offices, retail stores and factories and still have a high EBITDA. In addition, EBITDA assumes that the company collects all of its revenues from its customers, which excludes uncollectible customer returns and accounts receivable. In addition, a higher debt-to-EBITDA ratio is considered riskier, as the company may prove to be insolvent.
It is worth noting that EBITDA is considered as a non-GAAP measure which is not compliant with financial accounting standards and it is not used by all companies. In those cases, other measure such as EBIT or net income is used in the calculation of debt to income ratio.