Debt-to-earnings before interest, taxes, depreciation, and amortization (EBITDA) is a powerful ratio that measures the income available to pay down a company’s debt before considering interest, taxes, depreciation, and amortization expenses. A high result can signal a problematic debt load.
Banks frequently include debt-to-EBITDA targets in business loan covenants. Falling short may trigger immediate repayment. Similarly, credit rating agencies use this metric to assess default risk, where a high ratio may result in a lowered credit rating.
Key Takeaways
- Financial Gauging: Utilized by lenders, valuation analysts, and investors, the ratio reflects a company’s liquidity and financial health.
- Cash Flow Insight: Indicates how much actual cash flow is available to cover debt and liabilities.
- Trend Indicator: A declining ratio suggests debt repayment or earnings growth, whereas an increasing ratio indicates rising debt.
- Caution Required: Not an accurate measure of the company’s ability to pay debts as it excludes some key expenses.
Formula and Calculation
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Debt = Long-term and short-term debt obligations
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EBITDA = Earnings before interest, taxes, depreciation, and amortization
To find total debt, sum the company’s long-term and short-term obligations, located in the balance sheet under liabilities. EBITDA is derived from the income statement: add net income and line items for interest, taxes, depreciation, and amortization.
What the Debt-to-EBITDA Ratio Reveals
The debt-to-EBITDA ratio highlights how a company’s cash flow aligns with its debt payback capabilities, ignoring taxes, depreciation, and amortization. It offers a straightforward financial performance comparison among firms ignoring diverse financing structures and non-cash assets.
A lower ratio over time signifies that a firm is diligently paying off debt or innovating and enhancing earnings. In contrast, a rising ratio warns of increasing debt exceeding income capabilities.
Limitations of the Debt-to-EBITDA Ratio
While easy to calculate, the debt-to-EBITDA ratio can obscure true financial health. EBITDA, a non-GAAP measure, might mask losses through selective expense omission.
Interest is a significant debt-specific expense, directly affecting repayment. Industries with different capital requirements mean debt-to-EBITDA estimates must be within specific industry contexts to maintain accuracy. A 10 might be standard in fleet-heavy logistics, while a 3 indicates sound health in tech startups.
Example of Debt-to-EBITDA Ratio Application
Imagine Company A has $100 million in debt and $10 million in EBITDA, resulting in a debt-to-EBITDA ratio of 10. Five years down the line, the company halved its debt to $50 million and raised EBITDA to $25 million, resulting in a healthier debt-to-EBITDA ratio of 2.
Evaluating a Good Debt-to-EBITDA Ratio
Industry dynamics drive ‘good’ debt-to-EBITDA norms. Ratios exceeding 1.0 hint at significant debt. Knowing industry averages refines this assessment.
Comparing Debt vs. Equity Financing
Debt-to-equity ratios give insight into a company’s expenditure balance between debt and shareholder equity. Although lower ratios are favorable, the definitions vary with financial structure and industry trends.
Debt-to-EBITDA Rule of Thumb
General preferable limits hover between 3.0 and 5.0, yet rule depends hugely on industry and corporate specifics.
Conclusion
The debt-to-EBITDA ratio is vital for evaluating a company’s ability to manage debt through its income before covering major expenses. While insightful, its limitations remind investors to consider additional evaluations for comprehensive financial diagnostics.
Related Terms: Net Debt-to-EBITDA Ratio, Debt Load, Credit Rating, Income Statement, Balance Sheet
