What Is the Debt-to-EBITDA Ratio?

Debt-to-earnings before interest, taxes, depreciation, and amortization (EBITDA) is a ratio that measures the amount of income generated and available to pay down debt before a company accounts for interest, taxes, depreciation, and amortization expenses. A high ratio result could indicate a company has a debt load that might be too high.

Banks often include a certain debt-to-EBITDA target in the covenants for business loans, and a company must maintain this agreed-upon level or risk having the entire loan become due immediately. Credit rating agencies commonly use this metric to assess a company's probability of defaulting on issued debt. Firms with a high debt-to-EBITDA ratio may not be able to service their debt appropriately, leading to a lowered credit rating.

Formula and Calculation

$\text{Debt to EBITDA}= \frac{\text{Debt}}{\text{EBITDA}}$Debt to EBITDA=EBITDADebt​

where:

Debt = Long-term and short-term debt obligations

EBITDA = Earnings before interest, taxes, depreciation, and amortization

To determine total debt, add the company's long-term and short-term debt obligations. You can find these numbers in the company's balance sheet in the "Liabilities" section. You can calculate EBITDA using data from the company's income statement. Find its net income on the income statement, then add any interest expenses, taxes, depreciation, and amortization. Divide the debt by the company's EBITDA.

The debt-to-EBITDA ratio is similar to the net debt-to-EBITDA ratio. The main difference is the net debt-to-EBITDA ratio subtracts cash and cash equivalents while the standard ratio does not.

What the Debt-to-EBITDA Ratio Can Tell You

The debt-to-EBITDA ratio compares a company's total obligations to the actual cash the company brings in from its operations. It reveals how capable the firm is of paying its debt and other liabilities if taxes and the expenses from depreciation and amortization are deferred.

The ratio can also be used to compare companies without considering their financing methods and non-cash assets. This is useful because it provides a clearer picture of how debts can be paid.

A declining debt-to-EBITDA ratio is better than an increasing one because it implies the company is paying off its debt and/or growing earnings. Likewise, an increasing debt-to-EBITDA ratio means the company is increasing debt more than earnings.

Limitations of the Debt-to-EBITDA Ratio

Some analysts like the debt-to-EBITDA ratio because it is easy to calculate. Debt 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. In fact, companies often use EBITDA to hide or disguise losses over a period.

Depreciation and amortization are non-cash expenses that do not really impact cash flows, but interest on debt can be a significant expense for some companies. Banks and investors looking at the debt-to-EBITDA ratio to gain insight into how well the company can pay its debts may want to consider the impact of interest on debt-repayment ability, even if that debt will be included in new issuance. Some industries are more capital-intensive than others, so a company's debt-to-EBITDA ratio should only be compared to the same ratio for other companies in the same industry. In some industries, a debt-to-EBITDA of 10 could be completely normal, while a ratio of three to four is more appropriate in other industries.

Example of Debt-to-EBITDA Ratio

As an example, if company A has $100 million in debt and $10 million in EBITDA, the debt-to-EBITDA ratio is 10. If company A pays off 50% of that debt in the next five years while increasing EBITDA to $25 million, the debt-to-EBITDA ratio falls to two.

The Bottom Line

The debt-to-EBITDA ratio tells you how much income is available to pay debts before taxes, depreciation, and amortization are considered. The ratio is used by some analysts, but since certain expenses are not accounted for before the calculation, the metric is limited because it doesn't demonstrate the ability to pay debts from earnings after all expenses are paid.