Debt-To-EBITDA Ratio Defined & Explained (2024)

Susan GuilloryUpdated September 27, 2022

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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-EBITDA ratio might result in a lower credit score for your business, 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?

Before we go deeper into the debt-to-EBITDA ratio, it’s important to understand exactly what EBITDA is.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 + DepreciationRecommended: What Is EBITDA margin?

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/EBITDA ratio, however, is somewhat open to interpretation. Often, it’s defined as all interest-bearing liabilities, such as any types of 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.

Debt-to-EBITDA Ratio Formula

To calculate the ratio for debt to EBITDA, you would use this formula.Debt/EBITDA ratio = Liabilities/EBITDA

How the Debt-to-EBITDA Ratio Works

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/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/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.

Calculating Debt-to-EBITDA

Calculating the debt/EBITDA ratio is done by dividing a company’s short- and long-term debts by its EBITDA (earnings before Interest, Taxes, Depreciation, and Amortization). The main goal of this ratio is to reflect the amount of cash available with the company to pay back 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, before you get to the business loan application process, it can be smart to calculate your debt/EBITDA ratio 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/EBITDA. 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.

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. It’s 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/EBITDA ratio is also popular with analysts because it relates the debts of a company to its cash flows 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/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/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/EBITDA = $30 million/$10 millionDebt/EBITDA = 3A debt-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 $50 million in debt. This would be it’s ratio:Debt/EBITDA = $60 million/$10 millionDebt/EBITDA = 6Depending 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.

The Takeaway

The debt/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/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.

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Photo credit: iStock/sanjeri

Frequently Asked Questions

What is considered a good debt-to-EBITDA?

Is debt included in EBITDA?

What does debt-to-EBITDA indicate?

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About the Author

Susan Guillory

Su Guillory is a freelance business writer and expat coach. She’s written several business books and has been published on sites including Forbes, AllBusiness, and SoFi. She writes about business and personal credit, financial strategies, loans, and credit cards.

FAQs

Debt-To-EBITDA Ratio Defined & Explained? ›

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.

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What does the debt to EBITDA ratio tell you? ›

The net debt-to-EBITDA ratio is a debt ratio that shows how many years it would take for a company to pay back its debt if net debt and EBITDA are held constant. When analysts look at the net debt-to-EBITDA ratio, they want to know how well a company can cover its debts.

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How do you interpret EBITDA ratio? ›

A low EBITDA-to-sales ratio suggests that a company may have problems with profitability as well as its cash flow, while a high result may indicate a solid business with stable earnings. Because the ratio excludes the impact of debt interest, highly leveraged companies should not be evaluated using this metric.

What is EBITDA for dummies? ›

EBITDA, or earnings before interest, taxes, depreciation, and amortization, is an alternate measure of profitability to net income. By including depreciation and amortization as well as taxes and debt payment costs, EBITDA attempts to represent the cash profit generated by the company's operations.

How do you interpret the debt ratio? ›

Interpreting the Debt Ratio

If the ratio is over 1, a company has more debt than assets. If the ratio is below 1, the company has more assets than debt. Broadly speaking, ratios of 60% (0.6) or more are considered high, while ratios of 40% (0.4) or less are considered low.

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What is the best explanation of debt to income ratio? ›

Your debt-to-income ratio (DTI) is all your monthly debt payments divided by your gross monthly income. This number is one way lenders measure your ability to manage the monthly payments to repay the money you plan to borrow.

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What is a healthy EBITDA ratio? ›

Generally speaking, a good EBITDA margin for manufacturing businesses falls between 5% and 10%. However, this will vary depending on the specific industry you are manufacturing your products for, and how capital-intensive your operations are.

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Why is EBITDA misleading? ›

EBITDA is an oft-used measure of the value of a business. But critics of this value often point out that it is a dangerous and misleading number because it is often confused with cash flow. However, this number can actually help investors create an apples-to-apples comparison, without leaving a bitter aftertaste.

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Is a higher or lower EBITDA ratio better? ›

A good EBITDA margin is relative. However, a higher number in comparison with its peers in the same industry or sector indicates a greater level of profitability.

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Is EBITDA the same as income? ›

EBITDA is net income BEFORE taking out interest, tax, depreciation, and amortization expenses. So EBITDA will almost always be higher than net income. As we've seen, there are a few other key differences: Net income is a component in EPS, while EBITDA signals a company's earning potential.

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Is EBITDA higher than income? ›

This formula is: EBITDA = Net income + Interest + Taxes + Depreciation + Amortization. As you can see, net income is the starting point for calculating EBITDA. As such, EBITDA will almost always be higher than net income.

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Is EBITDA the same as profit? ›

Gross profit appears on a company's income statement and is the profit a company makes after subtracting the costs associated with making its products or providing its services. EBITDA is a measure of a company's profitability that shows earnings before interest, taxes, depreciation, and amortization.

What is a good debt ratio for a company? ›

Generally, a good debt ratio is around 1 to 1.5. However, the ideal debt ratio will vary depending on the industry, as some industries use more debt financing than others. Capital-intensive industries like the financial and manufacturing industries often have higher ratios that can be greater than 2.

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What does a debt ratio of 80% mean? ›

Debt ratio = (Total Debts/ Total Assets) * 100

If your debt ratio is 80%, this means that for each $1 owned, you owe 80 cents.

How is a debt ratio of 0.45 interpreted? ›

A debt ratio of 0.45 means that a firm has $0.45 of equity for every dollar of debt. A debt ratio of 0.45 means a firm has $0.45 of current liabilities for every dollar of current assets.

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What is considered high debt to EBITDA? ›

A high Debt-to-EBITDA ratio may indicate that a company has too much debt compared to its earnings, which can be a warning sign for investors and lenders. The ideal Debt-to-EBITDA ratio varies by industry, but a ratio below three is generally considered healthy.

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What is considered a high debt to EBITDA yield? ›

The higher a company's debt/EBITDA ratio, the more indebted it is. Agencies will usually only rate a company's bonds as investment grade if the debt/EBITDA ratio is less than two. Other companies must compensate for their higher ratios with higher yields to pay investors to take on the additional risk.

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