Debt/EBITDA Ratio

Updated on April 12, 2024
Article byKhalid Ahmed
Reviewed byDheeraj Vaidya, CFA, FRM

What Is the Debt/EBITDA Ratio?

The Debt-to-EBITDA ratio is a financial leverage metric used to measure a company’s ability and time taken to pay off its debt obligations using its financial leverage. It helps gauge the company’s available earnings and financial health to become debt-free.

Debt EBITDA Ratio

This ratio assesses a company’s creditworthiness and indicates its debt level. A higher ratio indicates a greater debt load and risk for investors, while a lower ratio suggests less debt and lower risk. Typically, a ratio of less than three is considered normal. In addition, the ratio is often used to determine a company’s financial stability by comparing its value to industry standards.

Key Takeaways

  • Debt-to-EBITDA is a financial ratio used to evaluate a company’s debt level relative to its earnings.
  • A high Debt-to-EBITDA ratio may indicate that a company has too much debt compared to its earnings, which can be a warning sign for investors and lenders.
  • The ideal Debt-to-EBITDA ratio varies by industry, but a ratio below three is generally considered healthy.
  • Credit rating agencies use this ratio to assess a company’s creditworthiness and set credit ratings.

Debt/EBITDA Ratio Explained

The Debt-to-EBITDA ratio indicates a company’s total debt to its EBITDA (earnings before interest, taxes, depreciation, and amortization). The ratio value can be used to assess a company’s financial health, whether positive or negative. Essentially, it represents the duration for which a company would have to maintain its current level of performance to meet its borrowing obligations.

Credit rating agencies use the Debt-to-EBITDA ratio to evaluate a company’s creditworthiness and ability to service its debt. However, credit rating agencies also consider other factors, such as the company’s revenue, cash flow, profitability, market position, and industry trends, in determining its credit rating.

The Debt-to-EBITDA ratio interpretation may vary depending on the industry and the specific company. For example, a ratio of 4 or higher may indicate a higher risk for some industries, while a 3 to 4 may be considered acceptable for others. Additionally, credit rating agencies use their internal rating scales to determine credit worthiness, which may not align with the ratios in the statement.

Lenders often include Debt-to-EBITDA ratio covenants in loan agreements, which specify the ratio’s maximum or minimum acceptable levels. Anyone can calculate the ratio value from a firm’s annual or quarterly financial statements by adding EBIT to the amortization and depreciation to get EBITDA and then dividing the total debt by the EBITDA.

While the Debt-to-EBITDA ratio is useful for assessing a company’s creditworthiness, it should be used with other financial and non-financial factors when evaluating its credit risk.

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Formula

The formula for the Debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio is as follows:

Debt-to-EBITDA = Total Debt / EBITDA

Where “Total Debt” refers to the sum of all the company’s interest-bearing liabilities, and “EBITDA” is a measure of a company’s operating performance that excludes non-operating expenses such as interest, taxes, depreciation, and amortization.

The formula for the Net Debt-to-EBITDA ratio is as follows:

Net Debt-to-EBITDA = (Total Debt – Cash and Cash Equivalents) / EBITDA

Where “Total Debt” refers to the sum of all the company’s interest-bearing liabilities, and “Cash and Cash Equivalents” refers to the liquid assets the company has on hand.

Calculation

To calculate the Debt-to-EBITDA ratio, follow these steps:

  • Determine the total amount of debt: This includes all interest-bearing liabilities, such as bank loans, bonds, and other long-term liabilities.
  • Determine the EBITDA: EBITDA is calculated by adding up a company’s earnings before interest, taxes, depreciation, and amortization. It is a measure of a company’s operating performance.
  • Divide the total debt by the EBITDA: This will give the Debt-to-EBITDA ratio.

To calculate the Net Debt-to-EBITDA ratio, follow these steps:

  • Determine the total amount of debt: This includes all interest-bearing liabilities, such as bank loans, bonds, and other long-term liabilities.
  • Determine the total cash and cash equivalents: It may include the company’s liquid assets.
  • Calculate the net debt: This is the total debt minus the total cash and cash equivalents.
  • Determine the EBITDA: EBITDA is calculated by adding up a company’s earnings before interest, taxes, depreciation, and amortization. It is a measure of a company’s operating performance.
  • Divide the net debt by the EBITDA: This will give you the net Debt-to-EBITDA ratio.

Here’s a simple example of how to calculate the Debt-to-EBITDA and Net Debt-to-EBITDA ratios:

Let’s assume that Company ABC has a total debt of $500,000, cash and cash equivalents of $100,000, and an EBITDA of $200,000.

Debt-to-EBITDA Ratio Calculation: 

Debt-to-EBITDA = Total Debt / EBITDA

= $500,000 / $200,000

= 2.5

Therefore, Company ABC has a Debt-to-EBITDA ratio of 2.5, meaning it has $2.50 of debt for every $1.00 of EBITDA.

Net Debt-to-EBITDA Ratio Calculation: 

Net Debt-to-EBITDA = (Total Debt – Cash and Cash Equivalents) / EBITDA

= ($500,000 – $100,000) / $200,000

= 2

Therefore, Company ABC has a Net Debt-to-EBITDA ratio of 2, meaning it has $2 of net debt (total debt minus cash and cash equivalents) for every $1 of EBITDA. This ratio considers the company’s cash and cash equivalents, giving a more accurate picture of its ability to service its debt obligations.

Example

Coffee Holding Co., Inc., a NASDAQ-listed company (NASDAQ: JVA), provides a good example for understanding the Debt-to-EBITDA ratio. The company has debt on its balance sheet, and its Net Debt-to-EBITDA ratio is 4.2. However, while its 0.67 times cover of super-low interest indicates its high leverage value, its business incurs significant depreciation and amortization charges, making the debt load appear heavier at first sight. This is because EBITDA measures the earnings of a firm generously.

However, the cost of debt has been negatively impacting shareholder returns recently, and the company’s EBIT fell to 82% last year. As a result, coffee Holding Co., Inc. may struggle to shed its debt if this downtrend continues.

Limitations

There appear to be certain limitations to the Debt-to-EBITDA ratio as follows:

  • First, this ratio cannot predict a company’s default rate.
  • Second, newly formed companies have negative values of the ratio. 
  • Third, sometimes cyclical companies face anomalous EBITDA making the ratio distorted.
  • Finally, when the ratio value becomes 1, total liability equals shareholder’s equity.
  • A value between 1.5 to 2.0 gets considered an acceptable ratio for small and medium-sized companies. However, bigger companies can have a value ratio above two but below 3.
  • A company with lower values of the ratio means that the company gets to grab benefits of the enhanced profits brought by financial leverage.
  • In rare cases, the ratio can be negative yet good for the company as it simply means it has more cash than its debt.

Frequently Asked Questions (FAQs)

Is a low Debt-to-EBITDA ratio always a positive sign for a company?

While a low ratio can positively indicate a company’s financial health, it may not always be true. For example, a low ratio could signal that a company is not taking advantage of potential growth opportunities, as it may be overly conservative in its borrowing practices.

How can a company improve its Debt-to-EBITDA ratio?

A company can improve its Debt-to-EBITDA ratio by reducing its debt levels and increasing its EBITDA through revenue growth, cost-cutting measures, or a combination of both. In addition, refinancing debt at lower interest rates could also lower the ratio, as it would reduce the cost of servicing the debt.

How does the Debt-to-EBITDA ratio differ from the Debt-to-Equity ratio?

While Debt-to-EBITDA and Debt-to-Equity ratios are measures of a company’s leverage, they differ in calculating its debt levels. The Debt-to-EBITDA ratio divides a company’s total debt by its EBITDA, a measure of its ability to generate cash flow. In contrast, the Debt-to-Equity ratio divides a company’s total debt by its equity, which measures its ownership value. 

This article has been a guide to what is Debt-to-EBITDA Ratio. We explain it with its formula, calculation, example, and limitations. You may also find some useful articles here –

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