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Debt-to-EBITDA: company's leverage ratio

How to assess the company's ability to repay its financial obligations?

DEFINITION:

Debt-to-EBITDA ratio (in Finnish, velka suhteessa käyttökatteeseen, velat/käyttökate) is used to determine the financial strength and health of the company, estimate its profitability and analyze the liquidity position of the entity.

This ratio indicates a company's ability to pay off its incurred debt, before covering such expenses as interest, taxes, depreciation and amortization. It shows approximately how many years it would take for a company to pay back its debt in case of debt and EBITDA to be constant.

FORMULA for calculations:

\[ {Debt\ to\ EBITDA\ Ratio} = {Total\ Debt \over EBITDA} \]
\[ {Debt\ to\ EBITDA\ Ratio} = {(ST\ Debt\ +\ LT\ Debt\ +\ FP\ Obligations) \over EBITDA} \]

WHERE:

  • EBITDA - Earnings before interest, taxes, depreciation, and amortization
  • ST Debt: Short-Term Debt
  • LT Debt: Long-Term Debt
  • FP Obligations: Fixed Payment Obligations

RESULT INTERPRETATION:

  • Debt-to-EBITDA ratio less than 3: normal financial state, when a company has sufficient funds to meet its financial obligations
  • Debt-to-EBITDA ratio higher than 4: extremely indebted company, which is likely to face difficulties in managing its debt burden
  • The higher the ratio, the greater the company's debt load and the longer it will take to pay off the debt. The debt-to-EBITDA ratio varies by industry, the same result may be considered as completely normal for some industries, whereas it can be inappropriate for others.

EXAMPLE:

Let's suppose, company's Debt-to-EBITDA ratio is 0,15 (15%). How many years (100% = 1 year) it may take for the company to generate enough cash to pay off its existing debt? If we assume that the debt and EBITDA are held constant, then it would be about two months.

And what if, for instance, Debt-to-EBITDA ratio equal to 4,3 (430%)? Then, such a company will need about 4 years and 4 months to pay down all of its debt.

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