What Is The Net Debt-To-EBITDA Ratio?
The net debt to EBITDA (earnings before interest tax desperation amortization) ratio calculates the financial leverage of a company and its ability to pay off debt. However, EBITDA can be better understood as a company's operating income.
The formula shows how many years the company would take to pay off its debt. It is preferred to see a lower debt-to-EBITDA value which shows that the company won't take as long to pay off its debt.
However, ratios vary between industries. Therefore, comparing companies in the same industry is important when using net debt to EBITDA as a valuation metric.
The formula is calculated by summing up a company's short and long-term debt, subtracted by their cash and cash equivalents, then divided by EBITDA. The derived figure will represent how long a company will need to operate to pay off its debt while sustaining its EBITDA levels.
Net Debt = Short-Term Debt + Long-Term Debt - Cash & Cash Equivalents
The company's net debt is then divided by EBITDA to give the ratio’s value.
Net Debt to EBITDA = Net Debt / EBITDA
What Net Debt-to-EBITDA Can Tell You
A positive net debt to EBITDA ratio tells investors that the company has excess debt. Therefore, it is okay for the ratio to be positive. However, a lower number is more appealing to investors. Some reasons why the Net Debt to EBITDA ratio is significant to investors are:
- The lower value further proves the company's debt is manageable, and it should be able to pay it off within the foreseeable future.
- A positive net debt to EBITDA ratio that is too high implies that the company is buried in debt. As a result, rating agencies will give the company a low rating due to the risk investors would be exposed to.
- A ratio of greater than 4 is a red flag to investors and reveals the company has too much debt. The company would have to offer higher interest rates on its bonds to compensate for that low rating.
Here is a simple layout of bond ratings:
| Moody's | Grade |
|---|---|
| Aaa | Investment |
| Aa | Investment |
| A | Investment |
| Baa | Investment |
| Ba, B | Junk |
| Caa/Ca/C | Junk |
| C | Junk |
Long-term debt is associated with high-interest payments that can burden a company’s net income.
The interest payments must be considered when modeling a company with a lot of long-term debt. This is because the more long-term debt a company holds, the more the company pays out in interest payments impacting the net income. Some factors to consider in a company's Net Debt to EBITDA ratio are:
- A reduced net income will reduce the company's future FCFE levels, affecting the calculation of the company's intrinsic value, the perceived price of a stock.
- The greater the net debt to EBITDA ratio, the longer the company will spend making interest payments, lowering the company's net income.
- It is possible to have a negative ratio as well. For example, if cash and cash equivalents exceed the company's debt, the debt to EBITDA will become negative. But this is a rarity.
Analysts and investors will also use the ratio for a horizontal analysis. Horizontal is a form of research where certain aspects of a company are taken and compared to the same or a similar company's information in past years.
Usually, ratios and financial statement items are considered to compare them to past periods to determine if the company is growing.
Analysts may use horizontal analysis of a company's net debt to EBITDA ratio to see how a company's debt is changing over time.
Example of How to Use Net Debt-to-EBITDA
For example, let's consider Company A’s financials.
After reviewing Company A’s 2021 filings, it was found that during the fiscal year, they reported short-term debt of $5 million, long-term debt of $20 million, and cash and cash equivalents totaling $10 million. Therefore, referring to the net debt formula, Company A currently holds $15 million.
Company A
- Short-Term Debt: $5,000,000
- Long Term Debt: $10,000,000
- Cash: $5,000,000
- Cash Equivalents: $5,000,000
From Company A’s filings, their EBITDA has been calculated to be $25 million. Therefore using the formula, the net debt of $15 million gets divided by EBITDA of $25 million to give Company A a ratio of 0.6.
Since that year, Company A has been showing a strong Net Debt to EBITDA ratio of 0.6, which proves the company has low current debt levels.
Using the company financials for the 2022 fiscal year, an analyst may perform a horizontal analysis against past years to determine how the company has been growing.
Within the past fiscal year, Company A had reported $7 million in short-term debt and $32 million in long-term debt. Cash equivalents increased to $17 million, and EBITDA was stated at $31 million. For the newest fiscal company filings, the net-to-equity ratio comes to 0.71.
From this, we can tell that Company A’s net debt to EBITDA has increased from 0.6 to 0.71, an 18.3% increase year over year. However, the ratio is still very low and shouldn't be alarming to investors as it should not take long to pay off the debt if EBITDA levels stay constant.
Conclusion
Calculating a company's net debt to EBITDA ratio is quite simple, which is why it is a common tool used by analysts and investors.
The information within the formula can all be found or derived from the data given in the company's filings. (Debt balances may be located within the balance sheet, while EBITDA can be calculated using figures from the income statement).
Yet, the simple calculation does not always satisfy analysis with the most accurate valuation of the company's earnings or available cash for debt repayment.
The ratio given is usually used by credit rating agencies to help gauge the company's rating. A lower ratio is preferred, showing the company is not burdened by debt; the higher ratios indicate the company is holding a lot of debt and will be given a lower credit rating on its bonds.
When assessing if a company can meet debt payments, loan obligations tend to specify restrictions that set a range under which they are looking for the assessee company's net debt to EBITDA to fall.
