Explanation of Debt to EBITDA Ratio

It's fairly normal for companies to carry some debt, but as with individuals, too much debt relative to how much money is coming in can be risky. Simply comparing how much debt two companies have doesn't tell you that much information unless you also look at other factors, like how much the companies are earning. A formula known as the debt-to-EBITDA ratio, or net leverage ratio, helps compute debt to earnings for companies of any size.

How EBITDA Works

EBITDA can be a bit of a tongue-twister of an acronym, but it's a common one to find in financial papers. It stands for earnings before interest, taxes, depreciation and amortization.

It refers to the net income or loss of a company, without subtracting factors like interest to lenders, taxes paid to the government, costs for depreciating the value of assets over their useful life or amortizing certain expenses over the period in which they're useful to an organization.

It's a measurement designed to focus on the core earning potential of the company rather than on factors relating to borrowing, taxes and the like. It's generally worth looking at both EBITDA and net income, with all these factors included, to get a full sense of how a company is doing.

Debt-to-EBITDA Ratio

As the name suggests, the debt-to-EBITDA ratio is how much the company owes divided by its EBITDA for a particular period, usually a year. Usually investors will look at the company's net debt, meaning its debt minus cash on hand, since they're trying to get a sense of how quickly the company can pay off its debts.

For example, a company owing $1,200,000 in outstanding loans that has $200,000 in the bank and an EBITDA of $500,000 has a net debt-to-EBITDA ratio of (1,200,000 - 200,000) / 500,000 = 2.

A lower debt-to-EBITDA ratio is considered less risky, since it means the company will have an easier time paying off its debts and will be less likely to fall into a cash crunch in a tight situation or if money is needed to grow the business and take advantage of new opportunities. You can often find a debt EBITDA benchmark for a specific industry if you're trying to decide what a healthy ratio for a company might be.

Ratios higher than four or five are often considered particularly risky, though this does vary based on the industry and other factors.

Other Leverage Ratio Formulas

The degree to which a company relies on borrowed money is often referred to as leverage. A mathematical tool for analyzing the level of leverage for a particular company is called a leverage ratio formula. Debt-to-EBITDA is just one such leverage calculation.

Others include debt-to-equity, which effectively measures the ratio of borrowed money to money invested in exchange for a stake in the company. A higher number means more risk for shareholders, who typically get paid back after lenders in the event of a bankruptcy.

Degree of Financial Leverage

Another measurement of how indebted a company is at a given time is what's known as the degree of financial leverage. That's the earnings before interest and taxes divided by the earnings before taxes, meaning with interest subtracted out.

A company with no debt, and therefore paying zero interest, will have a degree of financial leverage of 1. The more of a company's earnings are consumed by interest, the higher the degree of financial leverage will increase.

More financial leverage means more risk, since it leaves less room for additional borrowing and, often, more sensitivity to rising or falling interest rates, which can affect the company's profitability as well as ability to borrow additional money or refinance existing debt.