What it means
Net debt is total borrowings less the cash and cash equivalents the company holds. Deducting cash recognises that a business could use its cash balance to pay down some of its debt.
EBITDA stands for earnings before interest, tax, depreciation and amortisation, a measure of operating profit before financing costs and non-cash charges. Dividing one by the other gives a multiple, such as 2.0x or 4.0x.
A low figure suggests that the company could repay what it owes quickly from its earnings, while a high figure suggests heavy reliance on borrowing. What counts as high varies by industry, with stable, cash-generating businesses able to carry more debt than cyclical ones.
Lenders often write the ratio into loan agreements as a covenant, which is a promise to keep the ratio below a set level. If the company breaches the covenant, the lender may charge higher interest, demand a fee or call the loan.
Finance teams therefore monitor the ratio, forecast it and manage the debt and earnings that drive it. The ratio has limitations.
EBITDA ignores capital spending, tax and changes in working capital, so a business can have a flattering ratio and still have little free cash. The ratio also uses a single year of earnings, which can be misleading when profits are falling or unusually high.
Analysts often adjust the figures, for example by adding back one-off costs, including lease obligations in debt or using a forecast EBITDA. Because the definitions differ between companies and loan agreements, it is important to know exactly how each element is defined before comparing results.
The ratio is also useful in the opposite direction, to plan how much a business can borrow. If a lender will accept up to 3.0x and EBITDA is $50,000,000, the maximum net debt is 3.0 x 50,000,000 = $150,000,000.
Headroom against that limit tells the finance team how much room it has for acquisitions, dividends or investment before the covenant becomes a constraint.
In practice
Real-world examples
Example 1
A bank agrees a $200,000,000 loan to a manufacturer, with a covenant that net debt to EBITDA stays below 3.5x. Each quarter, the company's finance team reports the figures. When the ratio rises to 3.4x, the CFO speaks to the bank before the limit is reached.
Example 2
A private equity firm assessing the purchase of a services company with EBITDA of $20,000,000 plans to finance the deal with $100,000,000 of debt. The ratio would be 5.0x at purchase. The firm models how quickly cash flow would bring it down to 4.0x.
Example 3
A retail analyst compares two chains. One has a ratio of 1.2x and the other 3.8x, and both report similar profit margins. The analyst notes that the second chain would be more exposed if sales fell and credit became harder to obtain.
Think of it
Think of this like your personal mortgage compared to your annual salary. Your net debt is your remaining mortgage minus your savings, and your EBITDA is your take-home pay. The ratio tells you how many years of salary it would take to pay off your home if you used every penny of earnings.
Formula
Calculation
Net debt = Total debt - Cash and cash equivalents
Net debt to EBITDA = Net debt / EBITDA
Suppose a company has total debt of $400,000,000, cash of $100,000,000 and EBITDA of $75,000,000. Net debt = 400,000,000 - 100,000,000 = $300,000,000. Net debt to EBITDA = 300,000,000 / 75,000,000 = 4.0x. If EBITDA rose to $100,000,000 with the same net debt, the ratio would fall to 300,000,000 / 100,000,000 = 3.0x.Case study
Seen in the real world
Kingsfield Logistics is an illustrative, fictional haulage company with $180,000,000 of debt, $30,000,000 of cash and EBITDA of $50,000,000. Net debt was 180,000,000 - 30,000,000 = $150,000,000, so net debt to EBITDA was 150,000,000 / 50,000,000 = 3.0x, exactly at its loan covenant.
When fuel prices rose, EBITDA fell to $40,000,000, and the ratio would have risen to 150,000,000 / 40,000,000 = 3.75x, a breach. The CFO negotiated with the lender and sold surplus vehicles for $15,000,000, which was used to repay debt.
Net debt fell to $135,000,000, giving a ratio of 135,000,000 / 40,000,000 = 3.375x, still above the limit, so the lender agreed to a temporary higher covenant in exchange for a fee. The illustrative lesson is that the ratio can worsen through lower earnings as well as higher debt, so both sides of the fraction need watching.
Watch out
Common mistakes
- Ignoring how debt is defined, when lease obligations and other items may or may not be included.
- Treating a low ratio as proof of financial strength, when EBITDA excludes capital spending and tax that still need cash.
- Comparing ratios across industries without allowing for different norms for stable and cyclical businesses.
Questions
People also ask
What is a good net debt to EBITDA ratio?
There is no universal answer, but many lenders look for figures below about 3x for general businesses, with higher levels accepted in stable sectors and lower levels expected in cyclical ones.
Why use net debt instead of total debt?
Because cash on the balance sheet could be used to repay borrowings, so net debt gives a better view of the company's real borrowing burden.
What happens if the ratio exceeds a covenant?
The lender may charge a fee, raise the interest rate, require a repayment or, in serious cases, demand immediate repayment unless a waiver is agreed.