Most businesses do not make enough money initially to pay their business expenses like salaries, rentals, purchase equipment, and supplies for their functioning and growth. They will usually borrow the funds which they require for running their business from banks and other lenders. In other cases, established businesses will also borrow money from their lenders. Giving a loan is always risky for a lender, because there is a risk that the borrower may not repay the loan, and the lender will lose the money. Though the lender is usually asking for collateral, they will also want some information about the business finances.
The net debt-to-EBITDA ratio is a debt ratio for some companies that shows how many years it would take for a company to pay back its debt if net debt and EBITDA are held constant. The goal of this ratio is to represent how well a company can cover its debts. The difference between the debt-to-EBITDA ratio (DTER) and net debt-to-EBITDA ratio (NDTER) is that net debt subtracts cash and cash equivalents while the standard ratio does not. This ratio can be negative if the company has more cash than debt.
Let we learn in practice how we can use the Debt / Equity Ratio and Enterprise Value:
Before approving the loan application, the lender would like to find out more about the business profit margins, whether it is making enough money to repay the loan according to the repayment terms specified. One of the main parameters used to measure whether a business is making enough profit is the earnings before interest, taxes, depreciation and amortization, abbreviated as EBITDA. The interest and taxes can be substantial for a business and reduce the money available for making further investment. The depreciation and amortization expenses are non-cash expenses and some lenders do not consider these expenses while assessing whether the business can repay the debt.
For a business the debt is the amount which the business owes the lenders. The business may have loans which have to be paid over a longer period of time, which may be five years or more. This is the long term debt of the business. The business may have also raised funds by issuing bonds or borrowing from others for a shorter period of time, usually a few months or years and this is called short term debt. The total debt of a business consists of the long term and short term debt of the business. If a business faces any financial problem, repayment of the debt is given first priority, hence it is an important parameter for calculating the credit rating of a business.
Debt/EBITDA ratio formula
One of the popular parameters for determining whether a business is likely to repay the debt is the
Formula: Debt to EBITDA ratio = Debt / Ebitda
where debt is the total debt consisting of both the long and short term debt, and the EBITDA is calculated from the earnings of the business using the financial parameters described above. Both the debt and EBITDA are specified in financial statements of the business like the profit and loss statement, the balance sheet for a particular period. The ratio is also calculated periodically.
Net debt/EBITDA ratio formula
Often the business may have raised funds using short debt and has not used these funds. These funds are cash or cash equivalent for the business. If required the cash equivalent or cash can be used to repay the loans and other debt of the business immediately. Hence it is more relevant to calculate the
Formula: Net debt to EBITDA ratio (NDTER) = Net debt/EBITDA
where net debt = debt – (cash + cash equivalent)
Most borrowers prefer to use the net debt for calculating the ratio since it is the amount that is actually owned by the business and has to be repaid.
Typical value for Net-debt to EBITDA
The Net-debt to EBITDA ratio is an important ratio for investors and lenders to a business. It varies to a great extent depending on the business model and industry sector. This ratio is calculated periodically from the financial statements of the business. Most companies publicly declare their financial statements quarterly and annually, though the statements may be prepared internally, monthly. Usually, a low debt/Ebitda ratio is preferred for a business since it indicates that the business can easily pay off the debt in a few years. Typically for a well-run business, the ratio is usually 3 or 4. If the ratio is more than 5 , it could be a matter of concern. In some companies, the amount of cash and other cash equivalents is more than the debt of the company. So the net debt/EBITDA ratio may be negative in cash-rich companies.
Though lenders usually prefer businesses with a lower debt/EBITDA ratio, they should realize that the ratio depends to a large extent on the business model and industry sector. Some businesses do not require much capital investment so the ratio of these business will be lower. On the other hand, other industries especially in manufacturing require a huge amount of investment in equipment and machinery. Hence companies in these sectors will usually have a higher ratio. So while calculating the credit rating of a business, the industry sector should also be considered.
Banks and other lenders will check the credit rating of a business before lending any kind of money to it. They will usually not lend money to business which has a low credit rating or may charge a higher interest rate for lending the money. The terms for the loan will also be more stringent. One of the most widely used parameters for determining the credit rating of a business is the debt/EBITDA ratio. The lender will usually not give a loan to a business whose ratio is more than 5 unless there are some other factors that are considered. This may be specific industry sectors with higher capital, and also startup businesses. The lender may also specify that the borrower should maintain the debt/EBITDA ratio below a particular level in the terms and conditions of the loan. If the borrower is unable to maintain the ratio, the lender may initiate action against the borrower or demand immediate repayment of the loan.
Analysis for debt/EBITDA ratio
It is also recommended that a business, debtors, and investors should monitor the net debt and debt/EBITDA ratio over a period of time since it offers valuable insights into the functioning of the business. If the ratio is reducing over a period of time, it indicates that the business is paying off the debt, so the debt is decreasing, while the income is increasing or remaining the same. On the other hand, if the debt is increasing, it implies that the business is borrowing more for growth or expenses, and its income is not increasing in the same proportion. Business owners, investors, and debtors should analyze the variation in the ratio over a period of time and then make a decision accordingly. For example, investors may increase their stake in the business if the ratio is decreasing and sell their stake if the ratio is increasing.