What it means
EBITDA is used because it is a rough proxy for the cash a business generates from trading before financing and accounting choices get involved. Stripping out interest, tax, depreciation and amortisation makes two companies with different tax positions and asset ages more comparable.
The multiple is intuitive in a way most ratios are not. A result of three means the borrowings equal roughly three years of core earnings, and anyone can sense that eight would be uncomfortable while one would be relaxed.
Lenders write this ratio into loan agreements more often than any other. A covenant might require leverage to stay below 3.5 times, tested each quarter, and breaching it can trigger penalty pricing or immediate repayment even if every payment has been made on time.
What counts as acceptable varies with the reliability of earnings. Infrastructure and utilities regularly carry five or six times because revenue is contracted, while cyclical manufacturers and consumer businesses are usually held nearer two to three.
Net debt is commonly substituted for gross debt. Subtracting cash recognises that a company holding $2,000,000 in the bank is genuinely less leveraged than an identical one that has spent it, and buyers of businesses almost always negotiate on the net figure.
The measure has real weaknesses worth naming. EBITDA ignores the capital spending needed to keep assets working and ignores working capital swings, so a capital-hungry business can look far healthier on this ratio than its bank balance suggests.
In practice
Real-world examples.
Example
A private equity firm buying a laundry services business models an entry leverage of 4.5 times EBITDA. The plan is to grow earnings and pay down debt so that leverage falls below 2.5 times before a sale in year five.
Example
A brewery's quarterly covenant test comes in at 3.6 times against a 3.5 limit after a weak summer. Rather than default, it negotiates a temporary waiver in exchange for a fee and a commitment to defer a canning line purchase.
Example
An analyst compares two retailers with identical profits and notices one carries 1.8 times leverage and the other 4.6 times. In a downturn the second has far less room to absorb a drop in sales, which shapes the recommendation.
Formula
Calculation
Debt/EBITDA = Total debt / EBITDA, where EBITDA = Operating profit + Depreciation + Amortisation. Net debt/EBITDA = (Total debt - Cash) / EBITDA.
A packaging manufacturer reports operating profit of $3,300,000, depreciation of $900,000 and amortisation of $300,000, so EBITDA is $3,300,000 + $900,000 + $300,000 = $4,500,000. It carries total borrowings of $18,000,000, giving gross leverage of $18,000,000 / $4,500,000 = 4.0 times. The company also holds $2,250,000 of cash, so net debt is $18,000,000 - $2,250,000 = $15,750,000 and net leverage is $15,750,000 / $4,500,000 = 3.5 times. If its loan covenant caps net leverage at 3.75 times, the company is compliant but could take on only about $1,125,000 of additional net debt, or absorb a fall in EBITDA of about $300,000, before it breaches.Case study
Seen in the real world.
Alderwood Care Homes is an illustrative, fictional operator of six residential facilities, invented here to show how the ratio drives real decisions. It had borrowings of $27,000,000 against EBITDA of $6,000,000, giving leverage of 4.5 times, with a covenant limit of 5.0 times tested quarterly.
Wage inflation then pushed staffing costs up by $900,000 a year, cutting EBITDA to $5,100,000 and lifting leverage to roughly 5.3 times. The covenant was breached before management had fully absorbed what was happening, because the ratio moved through the earnings side rather than through any new borrowing.
The recovery in this fictional example took eighteen months. Alderwood sold one underperforming home for $4,000,000 and used the proceeds to repay debt, raised fees at the remaining five sites, and rebuilt EBITDA to $5,800,000 against $23,000,000 of borrowings, bringing leverage back to about 4.0 times. The board's conclusion was that leverage covenants are as much an earnings risk as a borrowing risk.
Watch out
Common mistakes.
- Treating EBITDA as cash. It excludes capital spending, interest, tax and working capital movements, so a business can post strong EBITDA while running short of cash.
- Comparing multiples across unrelated industries. A four times multiple that is normal for a regulated utility would alarm any lender to a fashion retailer.
- Forgetting that the denominator moves. Leverage can breach a covenant purely because earnings fell, with no new borrowing at all.
Questions
People also ask.
Should I use gross debt or net debt?
Use whichever the loan agreement specifies; net debt is more common in transactions, gross debt in conservative credit analysis.
What multiple is considered safe?
Under three times is generally comfortable for an ordinary trading business, though stable, contracted revenue supports considerably more.
Does operating lease liability count as debt?
Under current accounting standards most leases sit on the balance sheet, so they usually do, but the exact definition in the loan agreement governs.
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