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What the Debt-to-EBITDA Ratio Signifies and How to Calculate It

What the Debt-to-EBITDA Ratio Signifies and How to Calculate It
Susan Guillory
Susan GuilloryUpdated September 27, 2022
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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 a lender. One of the metrics they may look at is your debt/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/EBITDA is healthy.

What Is Debt-to-EBITDA?

Simply put, debt-to-EBITDA measures the ability of your company to pay its debts off. It compares your actual cash earnings to your financial obligations, including debt and other liabilities.A high debt-EBITDA ratio might result in a lower credit score for your business, whereas a lower ratio could positively impact your credit profile, making it easier to qualify for financing at favorable rates and terms.

What Is EBITDA?

Before we go deeper into the debt-to-EBITDA ratio, it’s important to understand exactly what EBITDA is.EBITDA stands for earnings before interest, tax, depreciation, and amortization. It is a measurement of a company’s profitability before those expenses are taken out. While not accepted by GAAP (generally accepted accounting principles, EBITDA is often used by analysts and investors to compare the profitability of two companies in the same industry. The reason 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 affects 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 + DepreciationRecommended: What Is EBITDA margin?

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/EBITDA ratio, however, is somewhat open to interpretation. Often, it’s defined as all interest-bearing liabilities, such as any types of 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 your debt-to-EBITDA ratio. All of these can help a lender understand the likelihood of your being able to repay a new loan with the given amount of debt you currently have.

Debt-to-EBITDA Ratio Formula

To calculate the ratio for debt to EBITDA, you would use this formula.Debt/EBITDA ratio = Liabilities/EBITDA

How the Debt-to-EBITDA Ratio Works

The debt/EBITDA ratio compares a company's total liabilities to the actual cash it is bringing in. The goal of this financial ratio is to show how capable the business is of paying its debt and other liabilities.Generally, the lower the debt-to-EBITDA ratio, the more money your company has available to cover its financial obligations when they come due. A higher debt/EBITDA ratio, on the other hand, suggests that the business is heavily leveraged and might run into trouble paying upon its debts. What’s considered a good debt/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 over leveraged and could potentially default on its debts. 

Calculating Debt-to-EBITDA

Calculating the debt/EBITDA ratio is done by dividing a company’s short- and long-term debts by its EBITDA (earnings before Interest, Taxes, Depreciation, and Amortization). The main goal of this ratio is to reflect the amount of cash available with the company to pay back its debts.

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, before you get to the business loan application process, it can be smart to calculate your debt/EBITDA ratio 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 keep 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/EBITDA. 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.

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.

Pros

Debt-to-EBITDA. It’s 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/EBITDA ratio is also popular with analysts because it relates the debts of a company to its cash flows by ignoring non-cash 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 are high, it could impact a company’s ability to pay debts.In addition, debt/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/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 calculate ABC’s debt-to-EBITDA ratio, you would calculate:Debt/EBITDA = $30 million/$10 million Debt/EBITDA = 3A debt-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 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 $50 million in debt. This would be it’s ratio:Debt/EBITDA = $60 million/$10 millionDebt/EBITDA = 6Depending on the industry, a ratio of 6 may be considered high and could make it difficult for XYZ to get a good credit rating and qualify for any additional financing. 

The Takeaway

The debt/EBITDA ratio reveals how much actual cash a company has available to cover its debt. It is 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 periodically calculate your company’s debt/EBITDA ratio. 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.

3 Small Business Loan Tips 

  1. Generally, it can be easier for entrepreneurs starting out to qualify for a loan from an online lender than from a traditional lender. Lantern by SoFi’s single application makes it easy to find and compare small business loan offers from multiple lenders.
  2. If you are launching a new business or your business is young, lenders will consider your personal credit score. Eventually, though, you’ll want to establish your business credit.
  3. If you need to borrow money to cover seasonal cash flow fluctuations, a business line of credit, rather than a term loan, provides the flexibility you likely need.

Photo credit: iStock/sanjeri
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Frequently Asked Questions

What is considered a good debt-to-EBITDA?
Is debt included in EBITDA?
What does debt-to-EBITDA indicate?

About the Author

Susan Guillory

Susan Guillory

Susan Guillory is the president of Egg Marketing, a content marketing firm based in San Diego. She’s written several business books, and has been published on sites including Forbes, AllBusiness, and Cision. She enjoys writing about business and personal credit, financial strategies, loans, and credit cards. Follow her on Twitter @eggmarketing.
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