Net Debt To EBITDA Ratio

Why should I care about net debt to EBITDA?

For markets: The net debt to EBITDA ratio is used by investors and analysts to gauge a company's financial leverage and by extension its overall health and therefore one measure of risk associated with investing in it. A lower ratio suggests that a company’s debt, relative to the size of its annual cash flow, is well-balanced, with the firm able to quickly reduce its debt using its earnings if it needs to. That, then, might make a company an attractive investment in the eyes of prospective buyers. On the other hand, a high ratio may indicate that a company is over-leveraged or in or close to financial distress, which could deter investment.

Zooming in: Understanding the net debt to EBITDA ratio helps investors evaluate the amount of debt a company carries as well as its capacity to service that debt through its operational earnings. For instance, a company with a decreasing net debt / EBITDA ratio over time might be improving its efficiency in generating revenue or managing expenses, or it could be successfully reducing its debt levels – all positive signals for that firm’s sustainability. That said, it could also highlight a company that’s inefficiently run: if a firm can stand to have higher debt levels because it’s able to service them, shareholders may prefer that the company takes on more debt as that leverage would boost their returns.

The bigger picture: Trends in net debt to EBITDA ratios can provide clues about economic conditions and industry standards. For instance, in industries where higher levels of debt are normal (like telecommunications or utilities), average net debt to EBITDA ratios will be much higher than in sectors where earnings are less predictable and therefore lenders are less willing to lend companies large amounts. Comparing these ratios can help identify which sectors are potentially over-leveraged and which are operating within healthy financial norms.

How to calculate net debt to EBITDA

Step 1: Calculate net debt

Net debt is calculated by subtracting a company’s cash and cash equivalents from its total debt.

• Net debt: Total debt (short-term and long-term) − cash and cash equivalents

• Total debt: This includes the sum of short-term and long-term debt obligations found in the liabilities section of the company's balance sheet.

• Cash and cash equivalents: This includes cash and assets that can be converted into cash immediately.

You can find these figures in a company’s balance sheet, as part of its regularly filed financial results.

Step 2: Determine annual EBITDA

EBITDA is a measure of a company’s earnings. It adds back interest, taxes, depreciation, and amortization to net income. By excluding non-cash charges like depreciation and amortization, as well as interest payments, it gives investors an approximation of the amount of cold, hard cash a company generates each year – cash it could use to repay its debt.

You can calculate EBITDA by making adjustments to a company’s income statement. The figures you’ll need to use in your adjustments are in the cash flow statement. Alternatively, companies will calculate it themselves and show it alongside other key metrics in their financial results.

• EBITDA = Net income + interest + taxes + depreciation + amortization
• Net income: This is the profit after all expenses have been deducted from revenues.
• Interest: These are the costs associated with debt.
• Taxes: Includes all taxes incurred.
• Depreciation and amortization: Non-cash charges that reflect the gradual reduction in value of the company’s fixed assets and intangible assets, respectively.

Step 3: Calculate net debt to EBITDA

Once you have the figures for net debt and EBITDA, divide one by the other to get the ratio.

• Net debt to EBITDA ratio = Net debt / EBITDA

What is a good net debt to EBITDA ratio?

All else equal, the lower the ratio, the lower the risk – which, for most investors, is better.

Anywhere up to 2 times is generally considered healthy and representative of a company’s strong debt-servicing capacity and therefore lowered default risk. Investors may tolerate net debt / EBITDA up to 3 if it’s in an industry where cash flows are stable and predictable.

A net debt / EBITDA at or above 4 might be a “red flag” to investors, suggesting that the company is at risk of being overwhelmed by its debts. However, investors’ conclusions rightly can vary by industry due to different capital requirements, structures, and business models across and within industries.

Net debt to EBITDA ratio by industry

The average net debt to EBITDA ratio for S&P 500 companies is 1.3. However, it’s more meaningful to consider industry-specific benchmarks that can provide a more precise guideline for evaluating a company’s net debt / EBITDA. The tables below show selected sectors with the highest and lowest net debt / EBITDA ratios as of June 2024. Note the analysis excludes financials (banks, asset management, insurance, REITs, and other real estate).

Selected industries with highest net debt / EBITDA. Source: Full Ratio.

Industries with high net debt to EBITDA ratios typically have a high proportion of fixed costs, regulated or highly predictable revenues – or some combination of the two. That allows them to, within reason, take on more debt as they’ve got a high degree of certainty about how much money they’ll earn in a year and therefore a high degree of confidence in their ability to meet their required interest payments.

Selected industries with lowest net debt / EBITDA. Source: Full Ratio.

Industries with low net debt to EBITDA ratios tend to be less predictable. Take biotech: a given drug being successful or approved is hard to predict, as therefore are future revenues, meaning only larger more established firms are likely to take on some debt. On the other hand, software and semiconductor companies are flush with cash given their typically capital-light business models and therefore show low leverage levels.

What does net debt / EBITDA tell you?

The net debt to EBITDA ratio tells you how leveraged a company is in relation to its cash earnings. It provides a view of a company's ability to cover its debts from its operational cash flow without relying on external funding sources.

Example of how to use a net debt to EBITDA ratio

Company A operates in the telecoms industry with $100 million in total debt, $20 million in cash, and an annual EBITDA of $50 million. Company A’s net debt to EBITDA ratio is:

• ($100 million − $20 million) / $50 million = 1.6

Assuming stable earnings, Company A would need approximately 19 months worth of cash flow to pay off all its debts.

Given the telecom industry has an average net debt / EBITDA of 2, an investor might conclude Company A has better-than-average financial health compared to its peers and therefore a lower risk profile. However, they might also conclude that Company A isn’t being efficient as its peers and could stand to take on more debt given the stability and predictability of the industry.

What are the limitations of net debt to EBITDA?

• Industry variability: Net debt to EBITDA ratios can vary significantly across different industries due to inherent differences in capital structure and business models. Industries that traditionally carry more debt, such as utilities or telecommunications, may have higher acceptable net debt / EBITDA benchmarks compared to other sectors. Therefore, using this ratio to compare businesses across industries without considering industry-specific benchmarks can lead to misleading conclusions.
• Business cycle sensitivity: In a downturn, a dramatic drop in EBITDA drives a higher net debt to EBITDA ratio, which might spook investors as companies appear riskier. If the drop-off is temporary or the company is quick in adjusting its debt, it might not be cause for concern in the long run.
• Excludes capital structure considerations: Net debt / EBITDA doesn’t consider the cost or structure of a company’s debt. A company with a reasonable net debt to EBITDA ratio might still be facing high interest costs that limit its ability to finance ongoing operations or expand.

Frequently Asked Questions on net debt to EBITDA ratios?

How can a company improve its net debt / EBITDA ratio?

A company can improve its net debt to EBITDA ratio by reducing its net debt, increasing its EBITDA, or a combination of both. Strategies include:

• Debt paydown: Allocating excess cash flow towards paying down outstanding debt reduces net debt.
• Enhancing cash flow: Improving operational efficiency and profitability increases EBITDA, which can involve optimizing costs, increasing revenue, or both.
• Asset sales: Selling non-core assets to generate cash, which can then be used to reduce debt.

What is the difference between net debt to EBITDA and debt to EBITDA ratio?

The primary difference is the inclusion of cash in the calculation. The debt to EBITDA ratio measures total debt against EBITDA, ignoring cash reserves. In contrast, the net debt to EBITDA ratio subtracts cash and cash equivalents from total debt, offering a view that reflects a company’s actual debt burden more accurately (since it could use its cash balance to pay down debt).

What does a negative net debt to EBITDA ratio mean?

A negative net debt to EBITDA ratio occurs when a company's cash and cash equivalents exceed its total debt, resulting in a negative net debt figure. This indicates that the company has more than enough cash to pay off its debt and still retain a surplus.