This is an ultimate complete guide on how to calculate Net Debt to EBITDA Ratio with detailed analysis, interpretation, and example. You will learn how to use its formula to assess an organization's debt repayment ability.
Definition - What is Net Debt to EBITDA?
The net debt to EBITDA ratio is essentially how many years it would take a company to pay back all its debts if its net liabilities and EBITDA are held constant.
For your information, EBITDA stands for Earnings before Interest, Taxes, Depreciation, and Amortization.
The net debt to EBITDA is a key profitability ratio for those who want to analyse the creditworthiness of a business.
The higher the ratio, the more concerned investors would be that the company is instead, leveraged too heavily and subsequently might face trouble paying off its debts.
The formula to measure the Net Debt to EBITDA ratio is as follows:
Net Debt to EBITDA Ratio = Net Debt / EBITDA
So divide the Net Debt of the business by the EBITDA which is the Earnings of the business Before Interest, Taxes, Depreciation and Amortisation.
So now the question is, how can we calculate the Net Debt?
You can use the following formula:
Net Debt = (Short-Term Debt + Long-Term Debt) - Cash & Cash Equivalents
You can easily find these numbers on a company’s financial statements.
ABC Rating Company wants to conduct an analysis on RMO Company to determine whether it has the ability to pay off its debts.
At the fiscal year ending December 31st 2015, RMO reported the following figures:
- Short-Term Debt = $7.00M
- Long-Term Debt = $27.00M
- Cash and Cash Equivalents = $12.50
- MEBITDA = $63.00M
We must then calculate as follows:
The workings show that RMO Company has a Net Debt/EBITDA ratio of 0.34 which, going by the general rule, is low.
Interpretation & Analysis
A high ratio of Net Debt/EBITDA would indicate that a company is excessively indebted and may not be able to pay this back and this would result in a potentially lower credit rating.
As a general rule a ratio of 5 or higher is considered to be too high and would be a cause for concern for rating agencies and investors.
It is often the case that Net Debt / EBITDA is part of a loan agreement made by the company and the lender which would set out that the company must remain at a certain ratio or else is required to pay back the loan.
On the other hand, a lower net debt / EBITDA ratio indicates that the company is able to meet its financial obligations and will have sufficient funds when they are due.
Cautions & Further Explanation
The net debt to EBITDA ratio is much more useful when the profitability of one company is compared to that of another within the same industry.
If is not appropriate to compare those within different industries as they can differ vastly in their capital requirements.
A high net debt / EBITDA may be less concerning if it is standard amongst other companies within the same industry.
Further, it is also risky to use the ratio to determine whether or not a company can pay back its debt as EBITDA does not take into account that there are likely to be accounts receivable and thus not all revenue may be earned.