The Debt/EBITDA Ratio compares the financial obligations of a company, inclusive of debt and other liabilities, to the actual cash earnings exclusive of the non-cash expenses.
The Debt/EBITDA Ratio is a common metric used by the creditors and rating agencies for assessment of the probability of defaulting on an issued debt. The Debt/EBITDA Ratio compares the financial obligations of a company, inclusive of debt and other liabilities, to the actual cash earnings exclusive of the non-cash expenses.
Debt/EBITDA Ratio Formula
The Debt/EBITDA Ratio is calculated by dividing the debts by the Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA).
Interpretation of Debt/EBITDA Ratio
The Debt/EBITDA Ratio is a popular metric because it relates the debts of a company to its cash flow while ignoring non-cash expenses. Cash flow, not profit, is ultimately used to pay off debts.
This ratio provides the investor with the approximate time required by a firm or business to pay off all debts, ignoring factors like interest, depreciation, taxes, and amortization.
Companies in good financial condition have a Debt/EBITDA Ratio less then 3. Ratios higher than 4 or 5 usually indicate that a company is likely to face difficulties in handling its debt burden.
The Debt/EBITDA Ratio can be used to compare liquidity of one company to another within the same industry. The ratio is not usually appropriate for comparison of companies in different industries. Capital requirements of other industries are different. Some industries are capital intensive and require larger amounts of borrowings to finance their operations.
Therefore, Debt/EBITDA Ratio may not give reliable conclusions when comparing different industries.