What is the Net Debt to EBITDA Ratio?
The net debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio measures financial leverageFinancial LeverageFinancial leverage refers to the amount of borrowed money used to purchase an asset with the expectation that the income from the new asset will exceed the cost of borrowing. In most cases, the provider of the debt will put a limit on how much risk it is ready to take and indicate a limit on the extent of the leverage and a company’s ability to pay off its debtSenior and Subordinated DebtIn order to understand senior and subordinated debt, we must first review the capital stack. Capital stack ranks the priority of different sources of financing. Senior and subordinated debt refer to their rank in a company's capital stack. In the event of a liquidation, senior debt is paid out first. Essentially, the net debt to EBITDA ratio (debt/EBITDA) gives an indication as to how long a company would need to operate at its current level to pay off all its debt. The ratio is commonly used by credit rating agenciesRating AgencyA rating agency is a company that assesses the financial strength of companies and government entities, especially their ability to meet principal and interest payments on their debts. The rating assigned to a given debt shows an agency’s level of confidence that the borrower will honor its debt obligations as agreed. to determine the probability of a company defaulting on its debt.
Net Debt to EBITDA Ratio Formula
The net debt to EBITDA ratio formula is as follows:
Where:
- Net debt is calculated as short-term debt + long-term debt – cash and cash equivalents.
- EBITDAEBITDAEBITDA or Earnings Before Interest, Tax, Depreciation, Amortization is a company's profits before any of these net deductions are made. EBITDA focuses on the operating decisions of a business because it looks at the business’ profitability from core operations before the impact of capital structure. Formula, examples stands for earnings before interest, taxes, depreciation, and amortization.
Practical Example of Net Debt to EBITDA Ratio
For example, McDonald’s Corporation reported the following figures for the fiscal year ending December 31, 2016:
The net debt to EBITDA ratio for McDonald’s is calculated as follows:
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Interpretation of the net Debt to EBITDA Ratio
A low net debt to EBITDA ratio is generally preferred by analysts, as it indicates that the company is not excessively indebted and should be able to repay its debt obligations. Conversely, if the net debt to EBITDA ratio is high, it indicates that a company is heavily burdened with debt. That situation would lower the company’s credit rating and investors would, therefore, require higher yields on bonds to compensate for the higher default risk. For McDonald’s Corporation, Standard & Poor’s (S&P) assigned a credit rating of BBB+, Moody’s assigned a credit rating of Baa1, and Fitch assigned a credit rating of BBB:
Source: Information compiled on Capital IQCapIQCapIQ (short for Capital IQ) is a market intelligence platform designed by Standard & Poor’s (S&P). The platform is widely used in many areas of corporate finance, including investment banking, equity research, asset management and more. The Capital IQ platform provides research, data, and analysis on private, public in 2018.
Generally, a net debt to EBITDA ratio above 4 or 5 is considered high and is seen as a red flag that causes concern for rating agencies, investors, creditors, and analysts. However, the ratio varies signficantly between industries, as each industry differs greatly in capital requirements. As a result, it is best used to compare companies in the same industry. In a loan agreement between the company and a lender, the lender often requires the company to remain below a certain net debt to EBITDA ratio.
Key Takeaways
- The Net debt to EBITDA ratio measures a company’s ability to pay off debt with EBITDAEBITDAEBITDA or Earnings Before Interest, Tax, Depreciation, Amortization is a company's profits before any of these net deductions are made. EBITDA focuses on the operating decisions of a business because it looks at the business’ profitability from core operations before the impact of capital structure. Formula, examples.
- The ratio is commonly used by credit rating agenciesRating AgencyA rating agency is a company that assesses the financial strength of companies and government entities, especially their ability to meet principal and interest payments on their debts. The rating assigned to a given debt shows an agency’s level of confidence that the borrower will honor its debt obligations as agreed. to assign a credit rating to a company.
- A low net debt to EBITDA ratio is preferred and indicates that the company is not excessively indebted.
- A high ratio indicates that the company has high debt levels and may consequently result in a lower credit rating (therefore mandating the company offer higher yields on bonds).
- An ideal net debt to EBITDA ratio depends heavily on the industry, as industries vary greatly in terms of average capital requirements. However, a net debt to EBITDA ratio of greater than 5 is usually a cause for concern.
- To ensure that a company is able to repay debt obligations, loan agreements typically specify covenantsDebt CovenantsDebt covenants are restrictions that lenders (creditors, investors) put on lending agreements to limit the actions of the borrower (debtor). Debt covenants are agreements between a company and its lenders that the company will operate within certain rules set by the lenders. List of top 10 debt covenants. that dictate the range which a company’s net debt/EBITDA ratio can fall under.
Related Readings
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- Debt CovenantsDebt CovenantsDebt covenants are restrictions that lenders (creditors, investors) put on lending agreements to limit the actions of the borrower (debtor). Debt covenants are agreements between a company and its lenders that the company will operate within certain rules set by the lenders. List of top 10 debt covenants.
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