The debt to EBITDA ratio is a leverage metric that measures the amount of income that is available to pay down debt before covering interest, taxes, depreciation, and amortization expenses. Put simply, debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) measures the company’s capability to settle its debt. A high deb/EBITDA ratio indicates that the company may have too much debt than it can handle. Often, creditors set a certain level for businesses to make sure that they are able to handle their debts. Rating agencies, the entity responsible for setting the level of confidence towards the borrower’s probability to honor its debt, are the ones who commonly use this ratio. Corporations that failed to reach the target debt to EBITDA would usually struggle to maintain or reduce its current level of debt. They’d have their credit rating lowered. Even worse, they might risk having all debt obligations defaulted immediately, making them more prone to enter a state of insolvency. To calculate this ratio, first, we need to get the value of total debt by summing short- and long-term debt from the balance sheet. Keep in mind that debt and liabilities are different. All debts are liabilities, but the opposite is not true. In other words, don’t add the entire companies liabilities. Only liabilities in the form of debt are taken into account. Some of the examples of non-debt liabilities that should not be added into the formula include accounts payable, accrued expenses, and wages payable. Most balance sheets separate debt and non-debt liabilities accordingly. So, identifying which numbers to put in is relatively easy. Otherwise, you can research each variable on the liabilities section of the balance sheet to make sure that any values included are also debt.
Debt to EBITDA Ratio Formula
The second variable we need is EBITDA. To calculate EBITDA, the standard & commonly used formula is:
Net income is the total profit after it’s freed from any kind of expenses. Eventually, net income will be divided as dividends to shareholders as well as retained earnings for future use. By adding back interest, taxes, depreciation, and amortization to net income, we can get the amount of revenue before these expenses are calculated but after any other costs are tallied. All of the figures to calculate EBITDA can be obtained from the income statement.
There’s another variation to the ratio called net debt to EBITDA. Net debt is the amount of total debt minus cash & cash equivalents owned by a company. Both debt to EBITDA and net debt to EBITDA have a similar goal of measuring a company’s ability to pay back its debt.
Debt to EBITDA Ratio Example
For this example, let’s take a look at the2019’s balance sheetandincome statementof American oil and gas corporation, Exxon Mobil Corp.
From the balance sheet, we can get the amount of short-term debt and long-term debt, which is $20,088 million and $32,679 respectively—the current portion of long-term debt is added to long-term debt.
Meanwhile, the EBITDA of the corporation is $30,762 million. What is the debt to EBITDA ratio?
Let’s break it down to identify the meaning and value of the different variables in this problem.
- Short-term Debt = 20,088
- Long-term Debt = 32,679
- EBITDA = 30,762
Now let’s use our formula:
In this case, the debt to EBITDA ratio is be 1.715.
We can see that the amount of total debt of Exxon Mobil is about 1.7 times bigger than its EBITDA. From a general point of view, having 1.715 of debt to EBITDA is considered low and generally acceptable by most industries standard. In some industries, even debt to EBITDA of 10 can be considered normal, while other fields may have a standard value of 3.
Debt to EBITDA Ratio Analysis
Leverage indicators such as the debt to EBITDA ratio are essential for creditors and lenders. It helps them make sure that a particular company will be able to continue to operate while managing its debt. Having too heavy debt is dangerous as firms may enter a state of insolvency. This can lead to bankruptcy in the foreseeable future. When such an event happens, the business may have to liquidate its remaining assets. And it’s often not enough to pay back the total outstanding debt to lenders as well as the portion to shareholders.
Analysts regard debt to EBITDA as one of the most accurate indicators of firms’ actual ability to pay its debts compared to other leverage measurements. This is the case because EBITDA is often seen as the closest figure to the real cash inflows a company receives, even more so than net income. Depreciation and amortization are not tangible expenses and may be neglected in some cases. Meanwhile, taxes are usually calculated only after the current portion of the debt has already been settled, while interest is relative to the debt obligations.
As good as it sounds, there are still limitations to the debt to EBITDA ratio. It only takes into account funds through earnings a company receives to pay off its debt. This occurs even though other cash sources may be available. There are also some cases where interest on debts is actually has a considerable impact on the company cash flows. Not including interest on the calculation may give an inaccurate impression in this case.
To get the most out of debt to EBITDA, you can compare the result of one company against its competitors in the same industry or past results.
Debt to EBITDA Ratio Conclusion
- The debt to EBITDA ratio is a metric measuring the availability of generated EBITDA to pay off the debt of a company.
- The formula requires 3 variables: short-term Debt, long-term Debt, and EBITDA (earnings before interest, taxes, depreciation, and amortization).
- All types of debt are liabilities, but not liabilities are debt. Only include liabilities in the form of debt instead of total liabilities into the calculation.
- This formula is seen as one of the most accurate leverage ratios since it includes EBITDA that better reflects a company’s real cash inflows than even net income.
- Debt to EBITDA is a very good indicator that gauges a business’s ability to pay back debt, but it still has its own flaws.
Debt to EBITDA Ratio Calculator
You can use the debt to EBITDA ratio calculator below to quickly calculate the availability of generated EBITDA to pay off the debt of a company by entering the required numbers.
FAQs
1. What is a debt to EBITDA ratio?
The debt to EBITDA ratio is a leverage indicator used as an assessment tool for companies seeking loans and other financial assistance. It helps creditors and investors determine the liquidity of a firm by comparing its earnings before interest, taxes, depreciation, and amortization (EBITDA) with its total debt.
2. How do you calculate the debt to EBITDA ratio?
The debt to EBITDA ratio is simply the total amount of short-term and long-term debts divided by EBITDA. The formula is:
Debt/EBITDA = Short-Term Debt + Long-Term Debt / EBITDA
3. What should be the target range for debt to EBITDA ratio?
In most cases, the target range of less than 3 indicates a strong financial standing. Anything above 3, however, may be undesirable. High ratios may mean that a company is unable to generate enough cash from operations to cover its short-term and long-term debts.
4. How do you interpret the debt to EBITDA ratio?
Debt to EBITDA ratio lower than 1.0 indicates that a company is generating enough cash from operations to cover its debts plus have excess funds for other purposes. If it’s lower than 3, then a company is doing well in managing its debt load, which means a low risk of default or bankruptcy. If it's higher than 3, then a company may be experiencing trouble in paying back its debts and is close to default or bankruptcy.
5. What does the debt to EBITDA ratio show?
The debt to EBITDA ratio shows how much earnings before interest, taxes, amortization, and depreciation (EBITDA) are available to cover existing debts. It also tells an investor if the company’s total debt load is too high to take on additional ones. Moreover, the ratio gives an idea of the kind of cash available to distribute among shareholders.
