Debt/EBITDA ratio is the comparison of financial borrowings and earnings before interest, taxes, depreciation and amortization. This is a very commonly used metric for estimating the business valuations. It is a good determinant of financial health and liquidity position of an entity. It is a measure of the ability of a company to pay off its debts. It compares the financial obligations of a company, inclusive of debt and other liabilities, to the actual cash earnings exclusive of the non-cash expenses.
Debt/EBITDA ratio can be used compare the liquidity position of one company to the liquidity position of another company within the same industry. A lower debt/EBITDA ratio is a positive indicator that the company has sufficient funds to meet its financial obligations when they fall due. A higher debt/EBTIDA ratio means that the company is heavily leveraged and it might face difficulties in paying off its debts.
Debt/EBITDA is one of the common metrics used by the creditors and rating agencies for assessment of defaulting probability on an issued debt. In simple words, it is a method used to quantify and analyze the ability of a company to pay back its debts. This ratio facilitates the investor with the approximate time period required by a firm or business to pay off all debts, ignoring factors like interest, depreciation, taxes, and amortization.
A high debt-EBITDA ratio might result in a lower credit score for the business. On the contrary, a lower ratio implies the firm’s desire to take on more debt, if required, thereby warning with a comparatively high credit rating.
The debt/EBITDA ratio is calculated by dividing the debts by the Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA).
Debt/EBITDA ratio = Liabilities / EBITDA
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.
Norms and Limits
The debt/EBITDA ratio is popular with financial analysts because it relates the debts of a company to its cash flows by ignoring non-cash expenses. Ultimately it is the cash flows (as opposed to profits) that will be used to pay off debts. Entities in normal financial state show debt/EBITDA ratio less than 3. Ratios higher than 4 or 5 usually set off alarms because they indicate that a company is likely to face difficulties in handling its debt burden, and thus is less likely to be able to raise additional loans required to grow and expand the business.
Debt/EBITDA ratio is not usually appropriate for comparison of companies in different industries. Capital requirements of other industries are different. Capital structure is different for companies operating in different industries. Some industries are capital intensive and require larger amounts of borrowings to finance their operations. Therefore, debt/EBITDA ratio may not give 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. Besides, the ratio is also helpful for the potential buyer in estimating the profitability of the company without the aggressive spending of the current manager. If, in case, the company does not spend much on purchase of new equipment or opening up new stores, it will have a lower depreciation and amortization costs thereby making the company profitable, not including these extra costs.However, it is a risky process to use the debt/EBITDA ratio for analyzing the debt repayment ability of a company. A company can spend huge amount of money on new offices, retail stores, and factories in spite of having a high EBITDA. Besides, EBITDA also presumes that the company collects whole of the revenue earned from its customers thereby not counting the uncollectible customer returns and accounts receivable. Moreover, a higher debt-EBITDA ratio is taken to be more risky as the company might come prove to be a default.