The debt to EBITDA ratio is a debt coverage ratio used by creditors and investors to assess a company's creditworthiness. Lenders considering making additional loans to a company that already holds debt typically calculate forward-looking debt to EBITDA ratios that incorporate the effects of the new loan into the company's debt coverage.
Debt to EBITDA is calculated by dividing the company's total interest-bearing debt by its earnings before interest, taxes, depreciation and amortization. The ratio provides an indication of how long it would take the company to reduce its debt balance to zero given its current EBITDA levels. For example, if a company has total debt of $5 million and annual EBITDA of $1 million, its debt to EBITDA ratio is calculated by dividing $5 million by $1 million, resulting in a debt to EBITDA ratio of 5.0. If the company allocated 100 percent of its EBITDA to debt reduction, it could reduce the balance by $1 million annually, taking five years to reduce the balance to zero.
Finding the Numbers
Interest-bearing debt is recorded on the company's balance sheet, which is a financial statement that summarizes the company's financial positions as of a given date, typically the end of a fiscal quarter or year. Debt is found on the balance sheet under current liabilities and long-term liabilities. Debt obligations that are shorter than one year, along with the current portion of long-term debt are recorded under current liabilities.
Earnings before interest, taxes, depreciation and amortization is both an earnings stream and a level of gross cash flow. Gross cash flow is calculated by adding back non-cash expenses such as depreciation and amortization to pretax earnings. EBITDA is a debt-free cash flow, because it does reflect reductions for interest expense.
Advantages and Disadvantages
EBITDA enjoys widespread acceptance as a financial metric among investors, but is less useful than free cash flow. The following summarizes the benefits and disadvantages of using EBITDA as a proxy for cash flow debt coverage. The disadvantages reflect EBITDA's tendency to overstate its capacity for debt coverage, particularly relative to free cash flow:
- EBITDA enjoys wide acceptance among investors and creditors. It is easy to calculate, using only the income statement and cash flow statement.
- Free cash flow is difficult to calculate and tends to be more erratic than EBITDA.
- EBITDA provides a good indication of the health of a company's operations independent of capital structure and depreciation methods.
- EBITDA does not include a reduction for capital expenditures, which results in a cash outflow. Capital expenditures can especially be high for companies that are capital-intensive and have substantial fixed assets.
- The basis for EBITDA, pretax earnings, does not reflect economic income, but rather income for accounting purposes, and is subject to manipulation.
- EBITDA does not account for working capital provisions, which can result in cash inflows and outflows, but in the long-term, generally reflect cash outflows.
- EBITDA is pretax, but many companies must pay income taxes.
- EBITDA does not reflect excess cash or idle assets which can be used to fund debt reductions.