The debt to EBITDA ratio formula compares the debt of a company to its earnings before interest, taxes, depreciation and amortization. In the covenants for business loans, banks usually include a certain debt/EBITDA target. Hence, a company must keep up the agreed-upon level or be at risk of having the whole loan become due at once. In regard to this, the debt to EBITDA calculation is commonly used by creditors and rating agencies to assess the defaulting probability of a company on an issued debt.

This article will discuss the debt to EBITDA ratio formula and calculation. But first of all, what is the debt to EBITDA ratio and how is it used?

Debt to EBITDA meaning

The debt to EBITDA ratio is a financial ratio that measures the amount of generated income that is available to settle debt before taking care of interest, taxes, depreciation, and amortization expenses. This ratio is a comparison of debt to EBITDA (earnings before interest, taxes, depreciation and amortization). It is commonly used for estimating business valuations and is a good indicator of a company’s financial health and liquidity position.

In order words, the debt/EBITDA is a metric used to analyze and quantify a company’s ability to pay back its debts. This means that companies with a high debt/EBITDA ratio may not be able to pay off their debt in an appropriate manner, leading to a lowered credit rating. The ratio makes it easier for investors to know the approximate time period required by a firm or business to pay off all debts, ignoring factors like interest, taxes, depreciation, and amortization.

See also Debt ratio

Use and relevance

The debt to EBITDA ratio is relevant for creditors and lenders to help them ensure that a particular company has the ability to operate continuously while managing its debt. It can be dangerous when a company has too many debts. This can cause the company to enter a state of insolvency which can lead to bankruptcy in the foreseeable future.

In an event of bankruptcy, the company may have to liquidate its remaining assets and usually find it hard to pay back the total outstanding debt to lenders and shareholders. Therefore, analysts use the debt to EBITDA as a metric to foresee and avoid such companies that are likely to go bankrupt.

They regard this ratio as one of the most accurate indicators of companies’ actual ability to pay their debts compared to other leverage metrics. The debt/EBITDA ratio is very relevant to analysts and creditors because EBITDA is usually seen as the closest figure to the real cash inflows that a company receives, even more than the company’s net income.

This ratio is very useful in management decisions. It can be used by a company interested in investing in a takeover bid. Moreso, the ratio is also helpful for the potential buyer as it can be used to estimate the company’s profitability without the aggressive spending of the current manager.

Lastly, the debt/EBITDA ratio is very relevant in comparing the liquidity position of one company to the liquidity position of another company within the same industry. This ratio can be used along with liquidity ratios like the quick ratio, cash ratio, and current ratio to compare the liquidity position of a company.

Debt to EBITDA ratio interpretation

What does debt to EBITDA tell you? The debt to EBITDA ratio interpretation is relevant to financial analysts. This is because the ratio relates the debt of a company to its cash flows by ignoring non-cash expenses. Ultimately, it is the cash flows that will be used to service debts.

A company’s debt to EBITDA ratio can be high or low. A debt/EBITDA ratio that is interpreted as low is a positive indicator that the company has sufficient funds to meet its financial obligations when they fall due. Whereas, a higher debt to EBTIDA ratio indicates that the company is heavily leveraged and is likely to have difficulties paying off its debts.

A high debt to EBITDA ratio is not good for a business as it can result in the business getting a lower credit score. Therefore, a high ratio result could mean a company has a too-heavy debt load. A lower debt to EBITDA ratio, on the other hand, indicates the company’s desire to take on more debt, if needed, thereby having a comparatively high credit rating.

Companies in a normal financial state show a debt to EBITDA ratio of less than 3. Therefore, debt to EBITDA ratios of more than 4 or 5 usually indicates red flags, indicating that the company is likely to have difficulties paying off its debts. Also, it is likely for such a company to be less able to raise additional loans needed to grow and expand the business.

Furthermore, it is usually not appropriate to use the debt/EBITDA ratio to compare companies in different industries. This is because the capital requirements of other industries are different and thus, the capital structure for companies operating in different industries varies. Some industries tend to be capital intensive and so require larger amounts of borrowings to finance their operations.

So, a high debt to EBITDA can be understandable in capital-intensive industries as debt financing is a norm. This means that comparing companies in such industries with another industry that is not capital intensive will not give a realistic result. Therefore, using the debt/EBITDA ratio to compare different industries, may not give reliable conclusions.

Related: Debt to capital ratio

More so, a debt to EBITDA ratio lower than 3.0, could mean that the company is doing well in managing its debt load, indicating that the company is at low risk of default or bankruptcy. But if the ratio is higher than 3.0, it is an indication that the company may be having difficulties paying back its debts and is at high risk of default or bankruptcy.

Nevertheless, before concluding that a company’s debt to EBITDA ratio is good or bad, it should be compared to the average debt to EBITDA ratio in the industry in which the company operates. The average debt to EBITDA ratio by industry varies due to certain factors. As said earlier on, some industries are more capital intensive than others. Therefore, the debt to EBITDA ratio should only be compared to the ratio of other companies in the same industry. For instance, for some industries, a debt/EBITDA of 3 or 4 is more appropriate, whereas a debt-EBITDA of 10 could be the norm in some industries.

Furthermore, a declining debt to EBITDA ratio is better than an increasing one. This is because a declining ratio indicates that the company is paying off its debt and is probably growing its earnings. An increasing debt/EBITDA, on the other hand, means that the company’s debt is increasing rather than its earnings.

The debt to EBITDA ratio formula

The debt to EBITDA ratio is gotten by dividing the company’s total debt by its earnings before interest, taxes, depreciation and amortization (EBITDA).

The debt to EBITDA ratio formula is expressed as:

Debt to EBITDA ratio= Total debt / EBITDA

Where,

Total debt= Short term and long-term debt

EBITDA= Earnings before Interest, Taxes, Depreciation, and Amortization

The essence of the debt to EBITDA formula is to reflect the available cash that a company has to service its debts, and not how much income is being earned by the company. Another variation to the debt to EBITDA ratio formula is the net debt to EBITDA.

The net debt to EBITDA is similar to the debt to EBITDA ratio but is calculated differently. The net debt to EBITDA formula is expressed as Net debt / EBITDA, where the net debt is the company’s total debt minus the cash & cash equivalents. As seen, the main difference is that the net debt/EBITDA ratio subtracts cash and cash equivalents while the debt to EBITDA ratio does not.

Related: Debt to asset ratio

Debt to EBITDA ratio calculation

The debt to EBITDA ratio calculation is done by dividing the company’s total debt by its earnings before interest, taxes, depreciation and amortization (EBITDA).

The value of total debt is gotten by summing up the short-term and long-term debt from the balance sheet. However, it is important to note that debt and liabilities are not the same. All debts are liabilities, but not all liabilities are necessarily debts.

Therefore, it is only the liabilities of the company that are in form of debt that should be taken into account when carrying out the debt to EBITDA ratio calculation. Do not add the company’s entire liabilities. Accounts payable, wages payable, and accrued expenses are some examples of non-debt liabilities that shouldn’t be added to the debt to EBITDA ratio formula.

For most balance sheets that separate debt and non-debt liabilities accordingly, it can be relatively easy to identify which numbers to put as debt into the debt to EBITDA ratio formula. But for those that are not separated, you may need to research each variable on the liabilities section of the balance sheet to ensure you input the right debt values.

Apart from the total debt of the company, the second variable needed for the debt to EBITDA calculation is the EBITDA. In order to calculate EBITDA, start with operating profit, also known as EBIT (earnings before interest and taxes), and then add back depreciation and amortization. The standard and common formula used to calculate EBITDA is expressed as:

EBITDA= Net income + Interest + Taxes + Depreciation + Amortization

The net income is the total profit of a company after it’s freed from any kind of expenses. This net income will eventually be divided as dividends to shareholders and as retained earnings for future use. By adding back interest, depreciation, taxes, and amortization to net income, one can get back the amount of revenue the company makes, before these expenses are calculated but after any other costs are tallied. All of the variables used to calculate EBITDA can be obtained from the company’s income statement.

Here are some examples of how to calculate debt to EBITDA ratio:

How to calculate debt to EBITDA ratio example 1

Let’s compare and carry out debt to EBITDA ratio calculation for 4 companies: Company A, Company B, Company C and Company D. Company A and Company B are in the manufacturing industry, while Company C and Company D are technology companies. After looking into the financial statements of these companies the following information in the table below was gotten:

	Company A	Company B	Company C	Company D
Total debt	$1.45 billion	$3.03 billion	$0	$3.94 billion
EBITDA	$1.45 billion	$616 million	$16.36 billion	$31.21 billion

Solution

Using the debt to EBITDA ratio formula:

Debt to EBITDA ratio= Total debt / EBITDA

Debt to EBITDA calculation for Company A

Debt to EBITDA ratio= $1.45 billion / $1.45 billion= 1.0

For Company B

Debt to EBITDA ratio= $3.03 billion / $616 million= 4.918

For Company C

Debt to EBITDA ratio= $0 / $16.36 billion= 0

For Company D

Debt to EBITDA ratio= $3.94 billion / $31.21 billion= 0.126

Debt to EBITDA ratio interpretation: As seen from the calculation done, the four companies have a different debt to EBITDA ratios. Company A and Company B are in the same manufacturing industry, but Company A has a debt/EBITDA of 1.0 and has a far more favourable debt coverage position than Company B.

Company B has a debt/EBITDA of 4.9 and appears to be is in the danger zone. Debt to EBITDA ratio higher than 3.0, is an indication that the company may be experiencing trouble in paying back its debts and is at high risk of default or bankruptcy.

Comparing Company C and Company D which are technology companies, it is seen that while Company C has about half the EBITDA of Company D, it also carries no debt. With no debt, the debt to EBITDA ratio of Company C amounted to 0.

Company D, on the other hand, has a strong EBITDA that even with almost $4 billion in debt the company was still able to have a favourable debt coverage position. The debt-EBITDA ratio of Company D is 0.12 indicating that the company is making enough cash to settle its debts and has the free cash flow for other purposes.

Conclusively, we can see that comparing the debt to EBITDA ratios of companies in different industries is not appropriate due to the differing capital structures across sectors. From our example, we compared Company A to Company B in the manufactury industry and Company C to Company D in the tech sector.

It would have been inappropriate for us to compare Company A to Company C or Company B to Company D. This is because the manufacturing industry that Company A and Company B belong require capital-intensive assets such as heavy equipment and factories for their operation. Technology companies, on the other hand, require less fixed assets.

Therefore, a high debt to EBITDA can be understandable in manufacturing industries as debt financing is a norm. This means that the high debt to EBITDA ratio of 4.9 that Company B has can be excusable if it is not way above the average debt to EBITDA ratio by industry.

How to calculate debt to EBITDA ratio example 2

From the balance sheet of Company XYZ, the amount of short-term debt and long-term debt is $20,088 million and $32,679 million respectively. Meanwhile, the EBITDA of the company is calculated to be $30,762 million from the income statement. Calculate the debt to EBITDA ratio.

Solution

We have the following variables:

EBITDA = $30,762 million

Short-term Debt = $20,088 million

Long-term Debt = $32,679 million

The debt to EBITDA ratio calculation using the formula:

Debt to EBITDA ratio= Total debt / EBITDA

Debt to EBITDA ratio= ($20,088 million + $32,679 million) / $30,762 million

Debt/EBITDA ratio= $52,767 million / $30,762 million= 1.715

Therefore, the debt to EBITDA ratio is 1.715

Debt to EBITDA ratio interpretation: As seen from the calculation done, Company XYZ has a debt to EBITDA ratio of 1.715. This means that the amount of total debt of Company XYZ is about 1.7 times bigger than its EBITDA. From a general point of view, debt to EBITDA ratio of 1.715 is considered low and generally acceptable by most industry standards.

Debt to EBITDA ratio lower than 3.0, could mean that the company is doing well in managing its debt load, indicating that the company is at low risk of default or bankruptcy. This means that the ratio of Company XYZ can be an acceptable debt to EBITDA ratio if it is lower than the average debt to EBITDA ratio by industry.

How to calculate debt to EBITDA ratio example 3

Assuming a company has $100 million in debt and $10 million in EBITDA, what will be its debt to EBITDA ratio? Now, if the company pays off 50% of that debt in the next five years with its EBITDA increasing to $25 million, what will be its new debt to EBITDA ratio?

Solution

We have the following variables:

Debt = $100 million

EBITDA = $10 million

Calculation using the debt to EBITDA ratio formula:

Debt to EBITDA ratio= Total debt / EBITDA

Debt to EBITDA ratio= $100 million / $10 million

Debt/EBITDA ratio= 10

In the next 5 years

If the company pays off 50% of $100 million, it means they paid off $50,000,000

The new debt we will be using to calculate the debt to EBITDA ratio will be:

$100 million – $50 million= $50 million

Remember the company’s EBITDA increased to $25 million in 5 years

We now have the following variables:

Debt = $50 million

EBITDA = $25 million

Debt to EBITDA ratio= $50 million / $25 million

Debt/EBITDA ratio= 2

Debt to EBITDA ratio interpretation: As seen from the calculation done, initially the company had a debt to EBITDA ratio of 10 but after 5 years the debt to EBITDA ratio dropped to 2. A declining debt to EBITDA ratio is better than an increasing one. It shows that the company is paying off its debt and is growing its earnings. More so the EBITDA increasing to $25 million is proof that the company is growing its earnings.

See also: Debt to equity ratio

Limitations of the debt to EBITDA ratio formula

Analysts like the debt to EBITDA ratio because calculating it is easy. The total debt used for the calculation is easily found on the balance sheet and EBITDA can be calculated from the income statement. The issue, however, is that the ratio may not provide the most accurate measure of earnings. Analysts want to estimate the amount of actual cash available for debt repayment and not just the company’s earnings.

Therefore, there are limitations to the debt to EBITDA ratio formula. Even though other cash sources may be available to pay off debts, the debt to EBITDA ratio formula only takes into account the funds through earnings that a company receives to pay off its debt.

Furthermore, there are also some instances where interest on debts actually has a considerable impact on the cash flow of the company. In such instances, not including interest in the debt to EBITDA ratio calculation may give an inaccurate impression.

Conclusion

The debt to EBITDA ratio measures the amount of generated income that is available to settle debt before taking care of interest, taxes, depreciation, and amortization expenses. It is commonly used by creditors and rating agencies to assess the defaulting probability of a company on an issued debt. The debt to EBITDA ratio formula requires 3 variables which include short-term debt, long-term debt, and EBITDA. It is expressed as Total debt/EBITDA.

This ratio is a very good indicator that tells a company’s ability to pay back debt, though it still has its own limitation. Even though other cash sources may be available to pay off debts, the debt to EBITDA ratio formula only takes into account the funds through earnings that a company receives to pay off its debt. Conclusively, in order to get the most out of the debt to EBITDA ratio, it is best to compare the result of one company to its past results or against its competitors in the same industry.