Deciphering Debt / EBITDA Ratio

Debt/EBITDA Ratio is commonly used by analysts and creditors to assess the creditworthiness of a business. It is used by your bankers to ensure that the company does not default in honoring its debt obligations and generates sufficient cash to pay off debt liabilities as and when it arises. Before putting any funds in a business, the bankers need to be sure that their money would be safe and would be repaid in time. This assurance is obtained by looking at the Debt/EBITDA ratio.

Debt/EBITDA ratio can be expressed as below:

Debt/EBITDA Ratio = Debt / EBITDA

EBITDA can be calculated from the income statement by adding interest expense, tax, depreciation and amortization to the profit after tax. It basically indicates the cash generated by the business and ignores non-cash expenses. The amount of debt can be located on the balance sheet. It is the sum of long-term debts and short-term debts.

This ratio indicates the number of periods in which the debt of a company can be repaid by the company through its own cash flows. As the earnings increase, the period in which the debt shall be paid off reduces.

If a business has total debt of Rs. 50 lakhs and EBITDA of Rs. 8 lakhs, the Debt/EBITDA ratio would be 6.25 (Rs. 50 lakhs divided by Rs. 8 lakhs). A declining Debt/EBITDA ratio is better than an increasing one. A decrease in Debt/EBITDA ratio indicates that the debt of the company is relatively reducing vis a vis its earnings.

However, this ratio is more useful for comparing companies in same industry. For comparing different investment options based on Debt/ EBITDA, it is not advisable to compare companies in different industries, as some industries may require high capital expenditure requiring more debt while others may not.

A low debt/ EBITDA ratio is viewed positively by the market and can obtain high credit rating for a business. It indicates that the company has high earnings as against the fixed obligations it has to honor on account of interest and principal repayments of debt. The opposite is true when the Debt/ EBITDA increases.

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