Loading the player…
What is ‘Debt/EBITDA’
Debt/EBITDA is a ratio measuring the amount of income generation available to paydown debt before deducting interest, taxes, depreciation and amortization. Debt/EBITDA is a measure of a company’s ability to pay off its incurred debt. The ratio gives the investor the approximate amount of time that would be needed to pay off all debt, ignoring the factors of interest, taxes, depreciation and amortization.
Commonly used by credit rating agencies to assess a company’s probability of defaulting on issued debt, a high Debt/EBITDA ratio suggests that a firm may not be able to service its debt in an appropriate manner and warrants a lowered credit rating.
BREAKING DOWN ‘Debt/EBITDA’
When analysts look at the debt/EBITDA ratio, they want to know how well a company can cover its debts. EBITDA is another way of saying earnings or income. Specifically, it is an acronym for earnings before interest, taxes, depreciation and amortization. Companies often look at EBITDA as a more accurate measure of earnings than net income. EBITDA is calculated by adding interest, taxes, depreciation and amortization to net profit. Some analysts see interest, taxes, depreciation and amortization as a manipulation of real cash flows. In other words, they see EBITDA as a cleaner representation of the real cash flows available to pay off debt.
Example of Debt/EBITDA and Interpretation
As an example, if company A has $100 million in debt and $10 million in EBITDA, the debt/EBITDA ratio is 10. If company A pays off 50% of that debt in the next five years, while increasing EBITDA to $25 million, the debt to EBITDA ratio falls to two. A declining debt/EBITDA ratio is better than an increasing one because it implies the company is paying off its debt and/or growing earnings. Likewise, an increasing debt/EBITDA ratio means the company is increasing debt more than earnings. Some industries are more capital intensive than others, so companies should only be compared against other companies in the same industry.
Analysts like the debt/EBITDA ratio because it is easy to calculate. Debt can be found on the balance sheet and EBITDA can be calculated from the income statement. The issue, however, is that it may not provide the most accurate measure of earnings. More than earnings, analysts want to gauge the amount of cash available for debt repayment. Depreciation and amortization are non-cash expenses that do not really impact cash flows, but interest can be a significant expense for some companies. Banks and investors looking at the current debt/EBITDA ratio to gain insight on how well the company can pay for its debt may want to consider the impact of interest on debt, even if that debt will be included in a new issuance. In this way, net income minus capital expenditures, plus depreciation and amortization may be the better measure of cash available for debt repayment.