Net Debt to EBITDA Ratio: Understanding Financial Leverage

The net debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio measures financial leverageFinancial LeverageFinancial leverage refers to the amount of borrowed money used to purchase an asset with the expectation that the income from the new asset will exceed the cost of borrowing. and a company’s ability to pay off its debtSenior and Subordinated DebtIn order to understand senior and subordinated debt, we must first review the capital stack. Capital stack ranks the priority of different sources of financing. Senior and subordinated debt refer to their rank in a company's capital stack.  In the event of a liquidation, senior debt is paid out first. 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 agenciesRating AgencyA rating agency assesses the financial strength of companies and government entities, especially their ability to meet principal and interest payments to determine the probability of a company defaulting on its debt.

Formula

The Debt to EBITDA ratio formula is as follows:

Where:

• Net debt is calculated as short-term debt + long-term debt – cash and cash equivalents.
• EBITDAEBITDAEBITDA or Earnings Before Interest, Tax, Depreciation, Amortization is a company's profits before any of these net deductions are made. EBITDA focuses on the operating decisions of a business because it looks at the business’ profitability from core operations before the impact of capital structure. Formula, examples 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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Interpretation

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 IQCapIQCapIQ (short for Capital IQ) is a market intelligence platform designed by Standard & Poor’s (S&P).  The platform is widely used in many areas of corporate finance, including investment banking, equity research, asset management and more. The Capital IQ platform provides research, data, and analysis on private, public 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.

Key Takeaways

• The net debt to EBITDA ratio measures a company’s ability to pay off debt with EBITDAEBITDAEBITDA or Earnings Before Interest, Tax, Depreciation, Amortization is a company's profits before any of these net deductions are made. EBITDA focuses on the operating decisions of a business because it looks at the business’ profitability from core operations before the impact of capital structure. Formula, examples.
• The ratio is commonly used by credit rating agenciesRating AgencyA rating agency assesses the financial strength of companies and government entities, especially their ability to meet principal and interest payments to assign a credit rating to a company.
• 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 covenantsDebt CovenantsDebt covenants are restrictions that lenders (creditors, debt holders, investors) put on lending agreements to limit the actions of the borrower (debtor). that dictate the range which a company’s net debt/EBITDA ratio can fall under.

Related Readings

Thank you for reading CFI’s explanation of the net debt to EBITDA ratio. CFI offers the Financial Modeling & Valuation Analyst (FMVA)™Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program and other training for financial professionals. To learn more and expand your career, explore the additional relevant CFI resources below.

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