What is the Net Debt-to-EBITDA Ratio?
The net debt-to-EBITDA (earnings before interest depreciation and amortization) ratio is a measurement of leverage, calculated as a company’s interest-bearing liabilities minus cash or cash equivalents, divided by its EBITDA.
The net debt-to-EBITDA ratio is a debt ratio that shows how many years it would take for a company to pay back its debt if net debt and EBITDA are held constant. However, if a company has more cash than debt, the ratio can be negative. It is similar to the debt/EBITDA ratio, but net debt subtracts cash and cash equivalents while the standard ratio does not.
The Debt to EBITDA ratio formula is as follows:
Net Debt to EBITDA Ratio = Net debt / EBITDA
- Net debt is calculated as short-term debt + long-term debt – cash and cash equivalents.
- EBITDA stands for earnings before interest, taxes, depreciation, and amortization.
What Net Debt-to-EBITDA Can Tell You
The net debt-to-EBITDA ratio is popular with analysts because it takes into account a company’s ability to decrease its debt. Ratios higher than 4 or 5 typically set off alarm bells because this indicates that a company is less likely to be able to handle its debt burden, and thus is less likely to be able to take on the additional debt required to grow the business.
The net debt-to-EBITDA ratio should be compared with that of a benchmark or the industry average to determine the creditworthiness of a company. Additionally, a horizontal analysis could be conducted to determine whether a company has increased or decreased its debt burden over a specified period.
For horizontal analysis, ratios or items in the financial statement are compared with those of previous periods to determine how the company has grown over the specified time frame.
Net Debt to EBITDA Analysis
The net debt to EBITDA ratio is favored by analysts because it considers a company’s debt-clearing capacity. A low net debt to EBITDA ratio is usually desired as it shows that a business is not buried in debt and will be able to cover its financial obligations with ease.
In contrast, a high net debt to EBITDA ratio is a sign that a company is too much in debt, which also means that its credit rating is low, and investors are likely to demand higher bond yields to buffer the greater risk that comes with lending it money.
Overall, the ratio is useful in decision-making, including decisions related to a takeover bid investment. Also, it’s helpful to potential buyers when in appraising the company’s profitability minus the current manager’s vigorous spending.
If the company is conservative in its spending when branching out or buying new equipment, its depreciation and amortization costs will be lower, making it profitable without the said extra expenses.
How to Improve Your Debt to EBITDA Ratio
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Limitations of Using Net Debt-to-EBITDA
Analysts like the net debt/EBITDA ratio because it is easy to calculate. Debt figures 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.
Example of How to Use Net Debt-to-EBITDA
Suppose an investor wishes to conduct horizontal analysis on Company ABC to determine its ability to pay off its debt. For its previous fiscal year, Company ABC’s short-term debt was $6.31 billion, long-term debt was $28.99 billion, and cash holdings were $13.84 billion.
Therefore, Company ABC reported a net debt of $21.46 billion, or $6.31 billion-plus $28.99 billion less $13.84 billion, and an EBITDA of $60.60 billion during the fiscal period. Consequently, Company ABC’s net debt-to-EBITDA ratio is 0.35 or $21.46 billion divided by $60.60 billion.
Now, for the most recent fiscal year, Company ABC had short-term debt of $8.50 billion, long-term debt of $53.46 billion, and $21.12 billion in cash. The company’s net debt increased by 90.31% to $40.84 billion year-over-year. Company ABC reported an EBITDA of $77.89 billion, a 28.53% increase from its EBITDA the previous year.
Therefore, Company ABC had a net debt to EBITDA ratio of 0.52 or $40.84 billion divided by $77.89 billion. Company ABC’s net debt to EBITDA ratio increased by 0.17, or 49.81% year-over-year.
Net Debt to EBITDA Conclusion
The net debt to EBITDA ratio shows how capable a company is to pay off its debt with EBITDA.
This formula requires three variables: total debt, cash and cash equivalents, and EBITDA.
The net debt to EBITDA ratio is usually expressed as a decimal number.
The ratio is typically used by credit rating agencies when assigning companies’ credit ratings.
A low net debt to EBITDA ratio is preferred and indicates that the company has a healthy level of debt
A high ratio shows that the company has too much debt, possibly leading to a low credit rating and a higher bond yield requirement.
A ratio higher than 5 should raise alarm.