A common phrase you hear in business is “you have to spend money to make money.”
Unfortunately, too many small business owners spend more money than they actually have…all in the name of getting their company off the ground or taking advantage of the next perfect opportunity. They hope that the money they bring in tomorrow will cover the money they’re spending today.
The end result of that kind of business strategy is a lot of debt.
One company owing money to another isn’t a cardinal sin of doing business. It happens all the time. For this post, we want to focus on how much debt is reasonable as a percentage of a company’s overall EBITDA (a common measure of cash flow derived as earnings before depreciation and taxes, depreciation, and amortization).
How to Calculate Debt as a Percentage of EBITDA
A company’s debt to EBITDA ratio measures its ability to pay off any debt that it has taken on.
Debt in this discussion includes all long-term and short-term financial obligations. So add these amounts together to come up with a total debt number.
Then divide total debt by your annualized EBITDA number. The result will be the ratio we’re looking for.
Debt / EBITDA = Debt to EBITDA
Often you will see references to “Net Debt to EBITDA”. This simply means that cash and cash equivalents were subtracted out of the formula.
( Debt – Cash & Cash Equivalents ) / EBITDA = Net Debt to EBITDA
What a Debt to EBITDA Ratio Shows
If that ratio is low, it indicates that your business is in a fairly healthy position. However, if the ratio is high, it means that there is a high debt load present and quite possibly not enough money available to adequately cover all of your financial obligations.
Financial institutions often use the Debt to EBITDA Ratio as a way of structuring loan agreements. They will set a target that the borrower must maintain. If the borrower exceeds the agreed-upon ratio, the bank may be able to call the loan and demand their money immediately.
Credit rating agencies will also use the ratio of Debt to EBITDA as a way of scoring a company’s creditworthiness. If a business has a high ratio, they will be given a lower score…thereby affecting their ability to borrow money.
The Net Debt to EBITDA Ratio is often preferred by analysts because it shows how quickly a company should be able to pay off its debts. If their cash position is high (represented by a low or even negative ratio), there will be much more confidence that their debt will be paid off in a shorter amount of time.
What is the Allowable Debt to EBITDA Ratio?
Although leverage can be useful in some cases, in general, the less debt your company has, the better.
When you aren’t having to allocate money to lenders, you get to keep more of it for yourself. That money can then be used to grow your business, take advantage of new opportunities, save for emergencies, and reward your employees.
According to the Corporate Finance Institute:
“Generally, net debt-to-EBITDA ratios of less than 3 are considered acceptable. The lower the ratio, the higher the probability of the firm successfully paying off its debt. Ratios higher than 3 or 4 serve as “red flags” and indicate that the company may be financially distressed in the future.”
Note: Many industries are more capital-heavy than others. A high debt ratio for them would not be as alarming as it would be in service industries. Therefore, it is important to compare similar industries (apples to apples) when evaluating whether or not a Debt to EBITDA ratio is too high.
How to Improve Your Debt to EBITDA Ratio
Southard Financial has been working with businesses of all sizes across all kinds of industries for over 30 years. We understand how important it is to have numbers that represent your company well to investors and stakeholders.
We perform hundreds of valuations every year, so we see it all. We understand how your Debt to EBITDA Ratio affects the value of your business…whether it’s important to you at the lending table now or when you sell your business later.
Schedule a call with one of our advisors today, and find out what Southard Financial can do for you.