What is debt to EBITDA Ratio?
Definition: EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Debt to EBITDA is a good ratio to determine the financial health and liquidity condition of an organization.
It is a measurement of a company’s profitability before deductions that are often considered irrelevant in the decision-making process.
In other words, it’s the net income of a company with certain expenses like amortization, depreciation, taxes, and interest added back into the total.
With the help of this ratio a company can able to measure the ability of a company to pay off its debts.
Advantage of debt to EBITDA Ratio
- It is a measurement a company’s profitability
- It provides the capability of a company to repay its debts
The disadvantage of debt to EBITDA Ratio
It doesn’t show the true value of the company because all of the costs associated with making a profit are not included
The formula of debt to EBITDA Ratio
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Analysis and Interpretation of Debt to EBITDA Ratio
This ratio is used to compare the liquidity position of one company to the liquidity position of another company within the same line of industry.
It’s a profitability calculation that measures how profitable a company is before paying interest to creditors, taxes to the government, and taking paper expenses like depreciation and amortization.
A lower ratio is a positive indicator that the company has sufficient funds to meet its financial obligations when they fall due.
A higher ratio implies that the organization is heavily leveraged and it would face difficulties in paying off its debts.
It is one of the common metrics utilized by the creditors and rating agencies for the assessment of defaulting probability on an issued debt.
In simple words, it’s a technique used to quantify and analyze the ability of an organization to pay back its debts.
This ratio facilitates the investor with the approximate period of time required by a firm or business to pay off all debts, ignoring factors like interest, depreciation, taxes, and amortization.
The normal financial state of a company shows a ratio of less than 3. Ratios above 4 or 5 usually set off alarms because they indicate that an organization is likely to face difficulties in handling its debt.
A high ratio might result in a less creditworthiness score for the business.
In other words, a lower ratio indicates the company’s longing to take on more debt, if necessary, thereby warning with a relatively high credit rating.
It is a way for calculation of profitability that is measured in dollars rather than percentages.
Example of Debt to EBITDA Ratio
For example, Ratiosys Technologies reported the following figures for the fiscal year ending March 31, 2020:
Debt to EBITDA Ratio = 40.25/9.50
Net Debt to EBITDA Ratio = 27.75/9.50
In general, net debt to EBITDA ratio above 4 or 5 is measured high.
Here 4.24 indicates that the firm measured high this ratio but net value 2.92 of this ratio is satisfactory even though investors or lenders will see all things at the time of lending with an open eye.
It is lookout as a red signal that causes alarm for rating agencies, investors, creditors, and analysts.
Although, the ratio varies appreciably between industries to industries differs significantly in capital requirements.
As a consequence, it is best suited to compare companies in the same line of activity.
In a loan agreement between a firm and a loan provider like the bank, the lender frequently requires the firm to remain below a certain net of this ratio benchmark.