The net debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio measures financial leverage and a company’s ability to pay off its debt. 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 agencies to determine the probability of a company defaulting on its debt.
The Debt to EBITDA ratio formula is as follows:
Net debt is calculated as short-term debt + long-term debt – cash and cash equivalents.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization.
Practical Example of EBITDA Ratio
For example, McDonald’s Corporation reported the following figures for the fiscal year ending December 31, 2016:
The Debt to EBITDA for McDonald’s is calculated as follows:
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A low net debt to EBITDA ratio is generally preferred by analysts, as it indicates that a 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 IQ 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 significantly 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 a company and a lender, the lender often requires the company to remain below a certain net debt to EBITDA ratio.
The net debt to EBITDA ratio measures a company’s ability to pay off debt with EBITDA.
A low 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 debt to EBITDA ratio depends heavily on the industry, as industries vary greatly in terms of average capital requirements. However, a 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 covenants that dictate the range which a company’s net debt/EBITDA ratio can fall under.
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