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If you’re considering taking out a business loan, you’ll want to make sure your company looks like a safe bet in the eyes of potential lenders. One of the metrics they may review is your debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio.
Debt-to-EBITA is a financial metric that looks at how much of the income your business is generating is available to pay down debt before covering interest, taxes, depreciation, and amortization expenses.
Read on to learn how this ratio is calculated and how to know if your company’s debt-to-EBITDA ratio is healthy.
Key Points
• Debt-to-EBITDA ratio measures a company’s ability to pay off its debt, comparing total debt to earnings before interest, taxes, depreciation, and amortization (EBITDA).
• Debt-to-EBITDA ratio indicates how many years it would take to repay debt, assuming no changes in earnings and no new debt.
• The debt-to-EBITDA formula is a company’s total debt — short-term and long-term — divided by EBITDA, while funded debt-to-EBITDA ratio looks at only long-term debt divided by EBITDA.
• A high debt-to-EBITDA ratio can lead to downgrades in credit ratings and affect a company’s ability to secure small business loans and other types of financing.
What Is Debt-to-EBITDA?
Simply put, debt-to-EBITDA measures the ability of your company to pay off its debts. It compares the business’s actual cash earnings to its financial obligations, including debt and other business liabilities.
A high debt-to-EBITDA ratio might result in a lower business credit score, whereas a lower ratio could positively impact your credit profile, potentially making it easier to qualify for financing at favorable rates and terms.
What Is EBITDA?
EBITDA stands for earnings before interest, tax, depreciation, and amortization. It’s a measurement of a company’s profitability before those expenses are taken out.
While not accepted by generally accepted accounting principles (GAAP), EBITDA is often used by analysts and investors to compare the profitability of two companies in the same industry.
The reason for this is that EBITDA removes expenses that can vary depending on a company’s capital structure (and how much it spends on interest on debt), historical investments (which affect its depreciation and amortization expenses), and tax burden (which can vary from state to state).
You can calculate EBITDA by looking at your income statement and adding interest, tax, depreciation, and amortization back to net income.
EBITDA = Net Income + Interest + Taxes + Amortization + Depreciation
Recommended: What Is EBITDAR?
What Is Debt?
Debt is anything your company owes another company or individual and includes both short-term and long-term debt obligations. You can find these numbers in a company’s quarterly and annual financial statements.
Exactly what obligations are included in total debt for the debt-to-EBITDA ratio, however, is somewhat open to interpretation. Often, it’s defined as all interest-bearing liabilities, such as small business loans.
If you want to take on more debt, lenders may look at financial metrics like your debt-to-income ratio, debt-to-equity ratio, and debt-to-EBITDA ratio. All of these can help a lender understand the likelihood of your company being able to repay a new loan with the given amount of debt you currently have.
Formula for Calculating Debt-to-EBITDA
Calculating the debt-to-EBITDA ratio is done by dividing the sum of a company’s short-term debts and long-term debts by its EBITDA.
To put it another way, to calculate the debt-to-EBITDA ratio, you would use this formula:
Debt-to-EBITDA Ratio = Total Debt / EBITDA
The main goal of this ratio is to reflect the amount of cash available at the company to pay back its debts.
Funded Debt-to-EBITDA Ratio vs Total Debt-to-EBITDA Ratio
If you calculate debt-to-EBITDA ratio but use just the long-term debt, the result is called a funded debt-to-EBITDA ratio. This metric focuses on interest-bearing, long-term debt, rather than short-term operational obligations — in contrast to total debt-to-EBITDA ratio, which includes both kinds of debt. Thus funded debt-to-EBITDA ratio may be more useful when you’re trying to evaluate a company’s long-term financial solvency;
What Is a Good Debt-to-EBITDA Ratio?
The debt/EBITDA ratio compares a company’s total liabilities to the actual cash it is bringing in. The goal of this small business financial ratio is to show how capable the business is of paying its debt and other liabilities.
Generally, the lower your debt-to-EBITDA ratio, the more money your company has available to cover its financial obligations when they come due. A higher debt-to-EBITDA ratio, on the other hand, suggests that the business is heavily leveraged and might run into trouble paying its debts.
What’s considered a good debt-to-EBITDA ratio will vary by industry. Generally speaking, however, a ratio of 4 or 5 is considered to be high. This may be a red flag to potential investors or lenders that your business is overleveraged and could potentially default on its debts.
Recommended: What Is EBITDA Margin?
Why the Debt-to-EBITDA Ratio Matters to Lenders
Your company’s debt/EBITDA ratio can be an important factor to lenders when they’re considering extending a loan to you. This metric is significant to potential lenders for several reasons.
Assessing Credit Risk
Before offering a loan to a potential borrower, lenders typically want to know that the borrower will be able to repay the loan. To gauge that ability, they may have business loan requirements relating to a variety of factors, including the owner’s credit history, the company’s credit score, and others. One of the key metrics is the company’s debt-to-EBITDA ratio since it shows how the company’s debt compares to its earnings, suggesting how much cash it may have available to repay new debt.
Evaluating a Company’s Financial Health
A company’s debt-to-EBITDA ratio, like its debt-to-income ratio, also suggests how well the company is doing financially. That’s because it indicates whether the business is able to pay its debts with the income it’s making. Lenders may consider this metric in order to gauge a company’s financial health, based on the metric and the standard in its industry.
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Uses of Debt-to-EBITDA
So when would you actually use your debt-to EBITDA ratio? If you’re looking to borrow money for your business, it can be smart to calculate your debt-to-EBITDA ratio before you start the business loan application so you know where you stand.
If you borrow money from a bank, there may be a requirement to meet a certain debt-to-EBITDA ratio in your loan agreement. If you can’t maintain that ratio, you may risk the loan being called.
If you are considering bringing on investors, they may also want to look at your debt-to-EBITDA ratio. Investors will often use this ratio to gauge the approximate amount of time it will take a company to pay off all of its debts with its available cash.
How Different Industries Use the Debt-to-EBITDA Ratio
What is considered an acceptable debt-to-EBITDA ratio varies from industry to industry. For example, for utilities and telecoms, which tend to have relatively predictable cash flow, a higher debt-to-EBITDA ratio may be considered acceptable. For technology and software companies, which can often grow quickly without incurring extensive debt, good debt-to-EBITDA ratios may be on the lower end. When you want to apply for a loan, it’s important to know what the expectation is in your industry so that you’ll understand how your company will be evaluated.
Recommended: What Is EBIDA?
Pros and Cons of Using the Debt-to-EBITDA Ratio
There are both benefits and drawbacks to using debt-to-EBITDA ratio to assess the financial health of a business. Here’s how they stack up.
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Pros:
• Easy to calculate
• Provides a snapshot of a company’s financial health and liquidity
• Relates debts to cash flows
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Cons:
• May not provide an accurate measure of earnings
• Interest on debt is excluded but can be a significant expense for some companies
• Not reliable for comparing companies in different industries
Pros
Debt-to-EBITDA is simple to calculate. Debt can be found on the balance sheet and EBITDA can be calculated from the income statement. As a result, this ratio can be a quick way to get a snapshot of a company’s financial health and liquidity.
The debt-to-EBITDA ratio is also popular with analysts because it relates the debts of a company to its business cash flow by ignoring noncash expenses. This is important because, in the end, it’s cash, and not profits, that is needed to pay off debts.
Cons
Because EBITDA adds interest, taxes, depreciation, and amortization to net income, it may not provide an accurate measure of a firm’s actual earnings. If any of these variables is high, it could impact a company’s ability to pay debts.
In addition, debt-to-EBITDA may not be useful for comparing companies in different industries. Capital requirements vary by industry and, as a result, some companies need to carry a higher debt loan than others. For this reason, using debt-to-EBITDA to compare firms across industries may not be reliable.
Debt-To-EBITDA Ratio Example
Let’s look at an illustration of how the total debt-to-EBITDA ratio can indicate a company’s financial health (or lack thereof).
Calculation Example
Let’s say company ABC’s EBITDA is $10 million and its debts add up to $30 million. To arrive at ABC’s debt-to-EBITDA ratio, you would calculate:
Debt-to-EBITDA = $30 million / $10 million
Debt-to-EBITDA = 3
A debt-to-EBITDA ratio of 3 is generally considered low and indicates that ABC has revenue to cover its debts. A lender may look at that ratio and decide that ABC isn’t a risk and approve a loan.
Here’s another example: Let’s say company XYZ has an EBITDA of $10 million, but has $60 million in debt. This would be its ratio:
Debt-to-EBITDA = $60 million / $10 million
Debt-to-EBITDA = 6
Depending on the industry, a ratio of 6 may be considered high and could make it more difficult for XYZ to get a good credit rating and qualify for any additional financing.
How to Interpret the Results
It’s important to be careful as you interpret your debt-to-EBITDA ratio. What is considered a healthy ratio varies considerably by industry, so it’s helpful to have a sense of the benchmark in the one in which your company operates. As discussed in the examples above, the metric will be understood by lenders in the context of what good numbers look like for other, comparable companies.
The Takeaway
The debt-to-EBITDA ratio reveals how much actual cash a company has available to cover its debt. It’s one of many financial metrics used by lenders, analysts, and investors to gauge a company’s liquidity and financial health.
As a business owner, it can be a good idea to calculate your company’s debt-to-EBITDA ratio periodically. It can give you insights into your company’s current financial position and also help you see trends over time. If you see the ratio going down, for example, it means that you are paying down debt, the company’s earnings are going up, or both.
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FAQ
What is considered a good debt-to-EBITDA?
What’s considered a good debt-to-EBITDA ratio will depend on your industry. Generally, however, a ratio of three or less can indicate that your business has enough cash flow to comfortably cover its debts.
Is debt included in EBITDA?
Yes. EBITDA stands for earnings before interest, tax, depreciation, and amortization. Interest represents the interest your business is paying on its debts.
What does a high debt-to-EBITDA ratio mean for a business?
A high debt-to-EBITDA ratio may suggest that the company might have difficulty paying back its debts or taking on new debt.
How can a company improve its debt-to-EDITDA ratio?
To improve debt-to-EBITDA ratio, a company could pay down its debt, increase its earnings, or both.
What are the limitations of the debt-to-EBITDA ratio?
Debt-to-EBITDA ratio has certain limitations. If a company is paying a lot for any of the elements that EBITDA adds to net income — interest, tax, depreciation, and amortization — its ability to pay back debt may be less than the debt-to-EBITDA ratio suggests. Additionally, if you’re using debt-to-EBITDA ratio to compare companies in different industries, you won’t necessarily get a useful result, since expectations of the ratio vary by industry.
What is the difference between debt-to-EBITDA and funded debt-to-EBITDA?
Debt-to-EBITDA ratio considers total debt, and funded debt-to-EBITDA uses just the interest-bearing, long-term debt.
Photo credit: iStock/sanjeri
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