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-to-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-to-EBITDA is healthy.
Key Points
• Debt-to-EBITDA ratio measures a company’s ability to pay off its debt, comparing total debt to earnings before interest, taxes, depreciation, and amortization (EBITDA).
• It indicates how many years it would take to repay debt, assuming no changes in earnings.
• The debt-to-EBITDA formula is total debt divided by EBITDA. It includes both short- and long-term liabilities.
• Lenders and investors closely monitor this ratio. A high debt-to-EBITDA ratio can lead to downgrades in credit ratings and affect a company’s ability to secure small business loans and other types of financing.
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-to-EBITDA ratio might result in a lower business credit score, 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?
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 + Depreciation
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-to-EBITDA ratio, however, is somewhat open to interpretation. Often, it’s defined as all interest-bearing liabilities, such as small 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.
Formula for Calculating Debt-to-EBITDA
Calculating the debt-to-EBITDA ratio is done by dividing a company’s short-term debts and long-term debts by its EBITDA. The main goal of this ratio is to reflect the amount of cash available with the company to pay back its debts.
Debt-to-EBITDA Ratio Formula
To calculate the ratio for debt to EBITDA, you would use this formula:
Debt-to-EBITDA Ratio = Total Debt / EBITDA
What the Debt-to-EBITDA Ratio Tells You
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-to-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-to-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.
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, it can be smart to calculate your debt-to-EBITDA ratio before you get to the business loan application 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-to-EBITDA ratio. 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.
Recommended: How to Read Financial Statements
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 | Cons |
|---|---|
| Easy to calculate | May not provide an accurate measure of earnings |
| Provides a snapshot of a company’s financial health and liquidity | Interest on debt is excluded but can be a significant expense for some companies |
| Relates debts to cash flows | Not reliable for comparing companies in different industries |
Pros
Debt-to-EBITDA is 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-to-EBITDA ratio is also popular with analysts because it relates the debts of a company to its business cash flow 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-to-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-to-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-to-EBITDA = $30 million / $10 million
Debt-to-EBITDA = 3
A debt-to-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 $60 million in debt. This would be it’s ratio:
Debt-to-EBITDA = $60 million / $10 million
Debt-to-EBITDA = 6
Depending 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.
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The Takeaway
The debt-to-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-to-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.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What is considered a good debt-to-EBITDA?
A good debt-to-EBITDA ratio will depend on your industry. Generally, however, a ratio of three or less can indicate that your business has enough cash flow to comfortably cover its debts.
Is debt included in EBITDA?
Yes. EBITDA stands for earnings before interest, tax, depreciation, and amortization. Interest represents the interest your business is paying on its debts.
What does debt-to-EBITDA indicate?
The debt-to-EBITDA ratio indicates how much income you have available to pay down debt before covering interest, taxes, depreciation, and amortization expenses.
Photo credit: iStock/sanjeri
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