The net debt-to-EBITDA (earnings before interest, depreciation, and amortization) ratio is a comprehensive measure of a company’s leverage. This ratio evaluates the extent to which a company’s earnings can cover its debt, factoring in its immediate liquid assets. Essentially, it indicates how many years it would take for a company to repay its debt if net debt and EBITDA remain constant. Intriguingly, if a company holds more cash than debt, the ratio can turn negative.
The Formula for Net Debt-to-EBITDA
The net debt-to-EBITDA formula is expressed as:
1Net Debt to EBITDA = (Total Debt - Cash & Equivalents) / EBITDA
Key Takeaways
- The net debt-to-EBITDA ratio reveals how many years a company would need to repay its debt under consistent conditions.
- Analysts use this ratio to gauge a company’s ability to service its debt efficiently.
- Unlike the traditional debt/EBITDA ratio, this metric considers cash and cash equivalents, offering a more nuanced picture of financial health.
- A higher ratio signals potential trouble for taking on additional debt; a negative ratio suggests higher cash reserves than debt.
What Net Debt-to-EBITDA Can Tell You
The net debt-to-EBITDA ratio is held in high regard by analysts for its ability to reflect a company’s capacity to manage debt effectively. Generally, a ratio exceeding 4 or 5 rings alarm bells, indicating possible difficulties in handling current debt levels and further financial obligations necessary for business growth.
To evaluate a company’s creditworthiness accurately, this ratio should be benchmarked against industry standards. A horizontal analysis can also shed light on how the company’s debt burden has evolved over time by comparing financial ratios across different periods.
Example of How to Use Net Debt-to-EBITDA
Consider an investor reviewing Company XYZ’s ability to manage debt through horizontal analysis. In the previous fiscal year:
- Short-term debt: $6.31 billion
- Long-term debt: $28.99 billion
- Cash holdings: $13.84 billion
- EBITDA: $60.60 billion
This results in a net debt of $21.46 billion and a net debt-to-EBITDA ratio of 0.35. In the most recent fiscal year:
- Short-term debt: $8.50 billion
- Long-term debt: $53.46 billion
- Cash holdings: $21.12 billion
- EBITDA: $77.89 billion
The net debt rises to $40.84 billion, pushing the ratio to 0.52. The company’s debt burden grows by 90.31%, with a net debt-to-EBITDA ratio increase of 0.17 over the year.
Limitations of Using Net Debt-to-EBITDA
Though easily computed, the net debt-to-EBITDA ratio might not always offer the most precise picture of financial health. Depreciation and amortization are non-cash expenditures, often making EBITDA a potentially misleading measure for cash flow.
To address this limitation, consider using net income minus capital expenditures, plus depreciation and amortization as an alternative metric for assessing available cash for debt repayment. This method encapsulates the significant role of interest costs, especially pivotal for enterprises with notable debt.Simplistic models might exclude interest rates, which could distort an accurate debt repayment capability evaluation.
Related Terms: Debt ratio, Leverage, EBITDA, Financial Health, Debt Management.
