What Is the Debt-to-EBITDA Ratio?

What Is the Debt-to-EBITDA Ratio?

Let me explain the debt-to-EBITDA ratio directly to you—it's a key financial metric that evaluates how well a company can pay off its debt using its earnings before we deduct interest, taxes, depreciation, and amortization. This ratio gives you insights into the business's financial health and liquidity. By looking at the income available to service debt, you as an investor or analyst can assess the risk and creditworthiness involved. The formula is straightforward: divide total debt by EBITDA, and you'll get a clear picture of the company's debt management.

Key Takeaways

You need to know that the debt-to-EBITDA ratio directly measures a company's ability to pay down debt with its earnings before interest, taxes, depreciation, and amortization. If the ratio is high, it signals a heavy debt burden that could impact the company's credit rating and overall financial stability. Investors and analysts rely on this to gauge liquidity and the capacity to meet obligations, ignoring cash flows from non-cash expenses. Remember, this ratio varies by industry, so what's good depends on typical levels in that sector. Use it carefully, as it doesn't account for all expenses and might not fully show a firm's true debt-paying ability.

How to Calculate the Debt-to-EBITDA Ratio

Calculating the debt-to-EBITDA ratio is simple—use the formula: Debt to EBITDA = Debt / EBITDA, where Debt includes both long-term and short-term obligations, and EBITDA is earnings before interest, taxes, depreciation, and amortization. Start by finding total debt from the balance sheet's liabilities section, adding up long-term and short-term items. Then, calculate EBITDA by taking net income from the income statement and adding back interest, taxes, depreciation, and amortization. Finally, divide the debt by EBITDA to get your ratio.

This ratio is similar to the net debt-to-EBITDA ratio, but the key difference is that the net version subtracts cash and cash equivalents from debt, while the standard one does not.

Important Note on EBITDA

Keep in mind that EBITDA is a non-GAAP measurement. If you see a company using it in reports, investigate further to understand their debt and actual earnings or income more deeply.

Insights Gained From the Debt-to-EBITDA Ratio

The debt-to-EBITDA ratio compares a company's total obligations to the cash it earns from operations, showing you its ability to pay debts if taxes and certain expenses are deferred. It lets you compare companies without considering their financing methods or non-cash assets. A declining ratio is better than an increasing one, as it means the company is paying off debt or growing earnings. On the other hand, an increasing ratio indicates debt is growing faster than earnings.

Understanding the Limitations of the Debt-to-EBITDA Ratio

Some analysts favor the debt-to-EBITDA ratio because it's easy to calculate—just pull debt from the balance sheet and EBITDA from the income statement. The problem is it might not give the most accurate earnings measure, as companies can use EBITDA to hide losses over time.

Depreciation and amortization are non-cash expenses that don't affect cash flows, but interest on debt can be a major expense for some firms. If you're a bank or investor using this ratio to check debt repayment, consider interest's impact, even for new debt issuances.

Industries differ in capital intensity, so compare a company's debt-to-EBITDA ratio only to others in the same industry. A ratio of 10 might be normal in one sector, while 3 to 4 is more fitting in another.

Example of Debt-to-EBITDA Ratio Application

Take company A with $100 million in debt and $10 million in EBITDA—the ratio is 10. If it pays off 50% of that debt over five years and boosts EBITDA to $25 million, the ratio drops to 2.

What Is a Good Debt-to-EBITDA Ratio?

A good debt-to-EBITDA ratio depends on the industry. Anything over 1.0 means more debt than earnings before taxes, depreciation, and amortization. Some industries handle more debt, others less—check the industry average first.

What Is a Good Debt-to-Equity Ratio?

The debt-to-equity ratio shows how much debt a company has relative to shareholders' equity. Since equity is part of total liabilities, it indicates the portion of debt financed by equity. Lower ratios are better, but 'good' varies by the business's structure and industry norms.

What Is the Rule of Thumb for Debt-to-EBITDA?

The rule of thumb varies by business and industry. Some say 3.0 is the limit, while others accept 4.5, 5.0, or higher.

The Bottom Line

In summary, the debt-to-EBITDA ratio measures how capable a company is of servicing debt with earnings before interest, taxes, depreciation, and amortization. It helps lenders, investors, and analysts evaluate financial health and liquidity. That said, while it's easy to calculate, it skips key expenses like interest, which can affect debt obligations. Use it with other metrics and in industry context for a full picture of stability.