Understanding Debt to EBITDA Ratio: Formula, Calculation, and Analysis

The Role of Debt-to-EBITDA in Indian Startups' Financial Health

The Indian startup ecosystem, recognized as the world’s third-largest, has been facing a challenging funding winter over the past few years. This situation intensified in the fiscal year 2023-24 (FY24), as the funding crunch led to thousands of job losses across multiple sectors.

Despite this, the first seven months of 2024 marked a surge in debt activity, with 68 debt deals amounting to $1.35 billion, representing over 75% of the $1.8 billion raised in the previous year. In FY24, the financial health of some of India's top companies improved significantly, with leverage ratios decreasing.

For example, among 275 BSE500 companies, the debt-to-EBITDA ratio fell to 2.7x—the lowest in nearly a decade. This marks a substantial decrease from the peak of 4.3x in FY20, showcasing a strong post-pandemic recovery. Such improvements in leverage provide a more stable foundation for growth, serving as a benchmark for startups managing their debt levels.

This is when understanding the debt-to-EBITDA ratio becomes imperative. It offers a clear picture of a company’s leverage, financial health, and ability to service its debt amidst fluctuating funding climates. This article will explore the formula, calculation, and analysis of the debt-to-EBITDA ratio and offer insights into evaluating financial stability amidst changing funding environments.

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Understanding Debt to EBITDA Ratio

The debt-to-EBITDA ratio is a vital financial metric that investors and analysts use to evaluate a company’s financial health and stability. It assesses a company’s ability to manage its debt by leveraging its earnings before interest, taxes, depreciation, and amortization (EBITDA).

• Definition: The debt-to-EBITDA ratio measures how much income is available to settle debt obligations before accounting for interest, taxes, and non-cash expenses. It provides insight into a company's operational performance and profitability from core business activities.
• Operational Performance: EBITDA reflects a company's ability to generate earnings from its primary operations, allowing for comparisons across companies without considering their financing methods or non-cash assets.
• Creditors' Perspective: Creditors often set specific thresholds for this ratio to ensure businesses can effectively meet their debt obligations. A clear picture of financial leverage aids stakeholders in making informed decisions regarding creditworthiness and investment potential.

Interpretation of the Ratio

• High Ratio: A high debt-to-EBITDA ratio indicates that a company may have more debt than it can manage effectively. 
• Increasing Ratio: An increasing ratio suggests that a company is accumulating debt faster than it is growing its earnings, which can lead to credit rating downgrades.
• Risk of Default: Companies failing to meet target ratios may struggle to maintain or reduce their debt levels, risking default on obligations and potential insolvency.

Statistical Context

As of March 31, 2024, the EBITDA multiples by sector provide valuable insights into the financial valuation of various industries. This section displays a chart summarizing the average EBITDA multiples across different sectors, highlighting how market conditions and industry performance influence these metrics.

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‍Debt to EBITDA Ratio Formula

The debt-to-EBITDA ratio is calculated by dividing a company’s short-term and long-term debts by its EBITDA. The core purpose of this ratio is to indicate the amount of cash the company has available to repay its debts. To calculate debt-to-EBITDA ratio, you can use the following formula:

Debt to EBITDA Ratio = Total Debt/ EBITDA

Where debt represents the overall liabilities, including short-term and long-term and EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It serves as an indicator of a company's profitability before accounting for these expenses.

​This ratio indicates how many years it would take for a company to pay off its debt if it devoted all its EBITDA to debt repayment. To calculate this ratio, you must first determine the total debt by adding short-term and long-term liabilities. 

“Debt and liabilities are different. All debts are liabilities, but the opposite is not true.”

Short-Term and Long-term Debt

Short and long-term debt provides a comprehensive view of a company's leverage and ability to meet immediate and future financial obligations based on earnings. It encompasses various financial obligations that companies incur based on the duration of their repayment periods. Check out the table that classifies long-term and short-term debt. 

• Short-Term Debt: This includes obligations that are due within one year. Short-term debt impacts the debt-to-EBITDA ratio by indicating a company's immediate debt-servicing ability. A higher proportion of short-term debt relative to EBITDA can highlight potential liquidity risks, signaling whether the company generates enough earnings to cover these immediate obligations​. Common examples are:

1. Bank loans or credit lines: Short-term loans taken for immediate financing needs.
2. Commercial paper: Unsecured promissory notes with maturities ranging from a few days to under a year.
3. Accounts payable and accrued expenses: Obligations to suppliers or costs must be paid shortly.
   
   

• Long-Term Debt: Long-term debt affects the debt-to-EBITDA ratio by showing the company's capacity to manage its long-term financial commitments. While long-term debt can support capital investments and expansion, an excessively high debt relative to EBITDA can suggest over-leverage, indicating the company may struggle to meet its long-term obligations​.
  These are obligations due beyond one year and include:

1. Long-term loans and bonds: Loans from financial institutions or bonds issued to investors that are repayable over several years.
2. Long-term leases: Financial commitments for assets like equipment or real estate with terms extending beyond one year.
3. Convertible debt: Debt that can be converted into equity shares, typically over a longer timeframe.

Understanding the Components of EBITDA

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a widely used financial metric that offers insights into a company's core operating profitability. Here's a breakdown of its components:

1. Earnings (Net Income): This represents the company's profit after all expenses, including interest, taxes, depreciation, and amortization, have been deducted. EBITDA starts with this net income figure and then adds other components to remove the effects of non-operating expenses.

2. Interest: Interest expenses are the company's costs on borrowed funds, such as loans or bonds. Since interest is related to a company's financing activities rather than its core operations, EBITDA excludes it from focusing solely on operating profitability.

3. Taxes: Taxes are mandatory contributions levied by governments on profits. These vary widely depending on location and tax regulations. EBITDA adds back taxes to avoid the impact of different tax rates across regions, allowing a more uniform comparison of companies' operational performance.

4. Depreciation: Depreciation allocates the cost of tangible assets (machinery and buildings) over their useful lives. It’s a non-cash expense, meaning no actual cash outflow occurs. Adding back depreciation allows EBITDA to reflect the cash generated from operations more accurately.

5. Amortization: Amortization is similar to depreciation but applies to intangible assets, such as patents, trademarks, or goodwill. It spreads the cost of these intangible assets over their useful life. Like depreciation, it’s a non-cash expense, and adding it back helps evaluate the company's operational performance.

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What is EBITDA Margin?

The EBITDA margin represents the relationship between a company's average earnings and its total revenue. It indicates how much cash profit a company can generate each year. Additionally, EBITDA is not explicitly recorded in a company's financial statements; therefore, investors and financial analysts must calculate it independently.

Example: Suppose a company has the following financial details:

• Revenue: ₹1000 crores 
• Cost of Goods Sold (COGS): ₹416.67 crores
• Overhead Expenses: ₹250 crores
• Depreciation & Amortization: ₹125 crores
• Interest Expense: ₹83.33 crores
• Tax Rate: 25%

Step-by-Step Calculation:

1. Calculate Operating Profit:
   Operating Profit =  Revenue - COGS + Overhead Expenses + Depreciation & Amortization
   Operating Profit = 1000 − (416.67 + 250 + 125) = ₹208.33 crores 
2. Earnings Before Tax (EBT):
   EBT= Operating Profit − Interest Expense
   EBT= 208.33 − 83.33 = ₹125 crores
3. Net Income After Taxes:
   Net Income = EBT× (1 − Tax Rate)
   Net Income = 125× (1 − 0.25) = ₹93.75 crores
4. EBITDA Calculation: Add back depreciation, amortization, interest, and taxes:
   Tax Expense = EBT × Tax Rate = 125 × 0.25 = ₹31.25 crores
   EBITDA = Net Income + Depreciation & Amortization + Interest Expense + Tax Expense

EBITDA = 93.75 + 125 + 83.33 + 31.25 = ₹333.33 crores

This example demonstrates how EBITDA clarifies a company's operational profitability by excluding non-operating expenses.

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How to Calculate Debt to EBITDA Ratio

To figure out the Debt-to-EBITDA ratio, here’s what you need to do:

1. Find the total debt: Start by adding up all the company’s debts, including anything it owes with interest, like bank loans, bonds, or other long-term debts. Make sure to include both short-term and long-term interest-bearing obligations.
2. Calculate EBITDA: Next, calculate the company's Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). You can get this by adding back interest, taxes, depreciation, and amortization to the company’s net income. This gives you a sense of the company’s earnings from its core operations before accounting for non-operating costs.
3. Divide total debt by EBITDA: Finally, take the total debt figure you found and divide it by the EBITDA you calculated. This gives you the debt-to-EBITDA ratio, showing how long it would take for the company to pay off its debt using its current earnings before those extra costs are factored in.

This ratio gives you a quick sense of a company's financial leverage and capability to handle its debt load based on earnings.

Example

Let’s understand the concept of debt-to-EBITDA ratio through a practical example. Here are the consolidated financial highlights for Hindalco for the quarter and year ended March 31, 2024, presented in a tabular format:

Consolidated Financial Highlights for the Quarter and Year ended March 31, 2024 (Rs. Crore)

Calculation of EBITDA

For the fiscal year 2024, Hindalco's consolidated EBITDA is calculated as follows:

1. Total Revenue from Operations: For FY2024, Hindalco reported a total revenue of ₹2,15,962 crore.
2. Business Segment EBITDA; The company breaks down its EBITDA into various segments. The total business segment EBITDA sums up to ₹27,857 crore including: 

• Novelis: ₹15,507 crore
• Aluminium Upstream: ₹9,161 crore
• Aluminium Downstream: ₹573 crore
• Copper: ₹2,616 crore

3. Inter-Segment Profit/Loss Elimination: Hindalco accounted for an inter-segment profit elimination of (₹60 crore).
4. Unallocable Income/Expense and GAAP Adjustments: The unallocable income/expense (net) and GAAP adjustments amounted to (₹2,069 crore).

Final EBITDA Calculation

The final EBITDA for Hindalco is calculated by adjusting the business segment EBITDA with the inter-segment eliminations and unallocable expenses:

EBITDA = Business Segment EBITDA + Inter Segment Profit Loss + Unallocable Income Expense
Substituting the values:

EBITDA = 27,857 + (−60) + (−2,069) = 25,728 crores

Thus, Hindalco's consolidated EBITDA for FY2024 is reported as ₹25,728 crore.

Quarterly Insights

For Q4 FY2024 specifically:

• The total revenue from operations was ₹55,994 crore.
• The EBITDA for Q4 FY2024 was reported as ₹7,201 crore, reflecting strong operational performance.

Summary of Key Insights Related to EBITDA

• Hindalco's consolidated EBITDA demonstrates a robust operational capability and reflects its ability to generate cash profits before accounting for interest, taxes, depreciation, and amortization.
• The increase in EBITDA from previous fiscal periods indicates effective cost management and revenue generation strategies across its various business segments.
• The breakdown of EBITDA by segment highlights the contributions of different business areas, with Novelis being a significant contributor.
• The company's financials reflect a healthy balance sheet and solid operational efficiency in FY2024.

These insights provide a comprehensive view of how Hindalco calculates its EBITDA and the factors influencing its performance in 2024.

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Significance of Debt to EBITDA Ratio

The debt-to-EBITDA ratio is essential for several crucial reasons: 

• Assessing Financial Risk: A high debt-to-EBITDA ratio indicates a company may be over-leveraged, increasing its vulnerability to market fluctuations and economic downturns. Such exposure can hinder a company's ability to maintain sustainable operations, as it may struggle to generate sufficient cash flow to meet its debt obligations. This risk is particularly pronounced in volatile markets, where earnings can fluctuate significantly, putting additional pressure on companies with high debt levels.
• Role in Creditworthiness Evaluation: Credit rating agencies heavily rely on the debt-to-EBITDA ratio when assessing a company's creditworthiness. A lower ratio generally reflects a stronger financial position, suggesting that the company can comfortably service its debt. Conversely, a higher ratio may signal potential difficulties in meeting debt obligations, leading to downgrades in credit ratings and increased borrowing costs. Rating agencies consider this metric alongside other factors such as revenue stability, cash flow, and overall market conditions.
• Comparative Analysis in Industry: The debt-to-EBITDA ratio is not a one-size-fits-all measure; it varies significantly across industries due to differing capital structures and cash flow characteristics. For example, industries like telecommunications may have higher acceptable ratios compared to sectors like technology or services. Therefore, comparing a company's debt-to-EBITDA ratio against industry averages is crucial for understanding its relative financial health.
• Tracking Debt Trends: Monitoring the debt-to-EBITDA ratio over time allows companies to track their financial health and sustainability. Regular calculations can reveal trends indicating whether a company is successfully paying its debt or increasing its earnings. A declining ratio over time is generally viewed positively, suggesting improved financial stability and operational efficiency.

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Interpreting Debt to EBITDA Ratio

Interpreting the debt-to-EBITDA ratio allows stakeholders to assess a company's financial standing and potential for future sustainability and growth. The following points outline guidelines for entrepreneurs to leverage the ratio's benefits. 

General Ratio Guidelines

While the general benchmarks below 2.0, between 2.0 and 4.0, and above 4.0 are applicable globally, the specific acceptable ratios can vary depending on the industry. For example, Indian companies in capital-intensive sectors like infrastructure or manufacturing might have higher acceptable debt-to-EBITDA ratios compared to companies in sectors like IT services. Let’s understand what these benchmarks signify:

• Below 2.0: A ratio under 2.0 typically signifies lower financial risk and indicates the company's solid capacity to service its debt.
• Between 2.0 and 4.0: Ratios in this range are considered moderate; however, caution may be necessary depending on the specific industry context.
• Above 4.0: A ratio exceeding 4.0 suggests a higher financial risk, raising concerns about the company's capability to meet its debt obligations.

Low, Moderate, and High Ratios

The interpretation of the debt-to-EBITDA ratio is highly dependent on the industry in which a company operates. Therefore, it's essential to consider industry-specific norms within India. For instance:

• Due to the higher capital requirements in industries such as telecommunications or utilities, a debt-to-EBITDA ratio of 10 might be deemed acceptable.
• Conversely, in less capital-intensive sectors, a ratio of 3 to 4 is often viewed as more appropriate and financially sound. 

Implications for Financial Health

Understanding the implications of the debt-to-EBITDA ratio involves considering various factors that affect a company’s ability to manage debt, such as:

• Economic Environment: The economic environment in India significantly impacts how stakeholders interpret the debt-to-EBITDA ratio. During periods of economic growth, lenders may exhibit greater tolerance for higher leverage, as companies are expected to generate robust cash flows. 

For instance, S&P forecasts indicate that Indian companies' average EBITDA is projected to be 50% higher in 2024 compared to the last five years, suggesting improved credit quality and financial health despite rising borrowings. Conversely, during economic downturns, lenders prefer lower ratios, reflecting a cautious approach to lending in uncertain times.

• Regulatory Framework: Different industries may have specific regulations or guidelines regarding acceptable levels of debt. For example, sectors like banking and finance are subject to stringent capital adequacy norms, which dictate how much leverage is permissible. This regulatory oversight can influence how companies manage their debt levels and their overall financial strategies.

Recur Insight: Investors and analysts must compare a company's debt-to-EBITDA ratio against industry peers to gain meaningful insights into its financial health. This comparative analysis helps identify whether a company's leverage is manageable or poses significant risks.

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Strengths and Limitations of Debt to EBITDA Ratio

The debt-to-EBITDA ratio provides valuable insights into a company's ability to manage debt obligations. Still, for a comprehensive financial assessment, it's essential to consider its strengths and limitations. 

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How to Analyze the debt-to-EBITDA?

This ratio is a leverage indicator for creditors and lenders, providing insight into a company's ability to manage its debt while continuing operations. A high level of debt can pose significant risks, potentially leading to insolvency and bankruptcy, which may force a company to liquidate its assets. Unfortunately, such liquidations often fail to cover the total outstanding debts owed to lenders and shareholders.

Analysts consider the debt-to-EBITDA ratio one of the most reliable measures of a firm's capacity to meet its debt obligations. This reliability stems from the fact that EBITDA reflects the company's operational cash inflows more accurately than net income, as it excludes non-cash expenses like depreciation and amortization. 

However, this ratio primarily involves earnings as the source of funds for debt repayment, overlooking other potential cash sources. In some cases, interest payments can significantly impact cash flows, and excluding them from calculations may create a misleading picture of financial health. This is why, when evaluating a company's debt-to-EBITDA ratio, several factors should be considered. These factors include: 

1. Industry Norms: The acceptable debt-to-EBITDA ratio can differ widely depending on the industry. Understanding these norms is essential for accurate comparisons.
2. Growth Prospects: A company's growth trajectory is also essential. For instance, a business in a high-growth sector may have a lower debt-to-EBITDA ratio than one in a mature market, but this does not necessarily indicate greater efficiency.
3. Interest Expenses: Interest can represent a substantial expense for many companies. Therefore, it is crucial to assess how interest impacts overall cash flow and debt servicing capabilities.
4. Credit Rating: A lower debt-to-EBITDA ratio often correlates with a better credit rating than industry averages, indicating stronger financial health.
5. Debt-Servicing Capacity: A ratio below 2.0 typically indicates lower financial risk and robust debt-servicing capability.
6. Risk Profile: Comparing the risk profiles of companies within the same industry and capital structure is vital for meaningful insights.

While the debt-to-EBITDA ratio is an invaluable tool for assessing financial stability and creditworthiness, it should be interpreted with caution and context-specific considerations in mind. For more insights, check out some best practices to prevent mistakes while analyzing the debt-to-EBITDA ratio here.  

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Practical Applications

• Use in Loan Agreements: Lenders often use the debt-to-EBITDA ratio to set covenants in loan agreements, ensuring that companies maintain manageable debt levels. A high ratio may lead to stricter borrowing terms or higher interest rates.
• Investor Usage: Investors rely on this ratio to assess a company's leverage and risk. It helps them evaluate the company's ability to generate enough earnings to cover debt obligations.
• Strategic Decision-Making: Companies use this ratio for strategic planning, such as deciding on acquisitions or expansions, ensuring they maintain healthy leverage. 

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Additional Factors Influencing Real-World Valuations 

Beyond industry standards and EBITDA range, real-world valuations depend principally on 8 other factors, including: 

• Recurring Revenue: Stability in revenue streams enhances predictability in cash flows.
• Revenue Growth Over Last 12 Months: Consistent growth signals operational effectiveness and market demand.
• Key Employee Turnover: High turnover can indicate instability and affect company performance.
• Profit Margin: Healthy margins suggest efficient cost management and profitability.
• Competitive Advantages: Unique strengths can differentiate a company in the marketplace.
• Customer Concentration: A diverse customer base reduces the risk associated with revenue loss from any single client.
• Strength of Management Team: Effective leadership is crucial for navigating challenges and driving growth.
• Growth Opportunities: Potential avenues for expansion can enhance future profitability.

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To Sum Up

The debt-to-EBITDA ratio is a fundamental metric that plays a significant role in assessing a company's financial health. By evaluating this ratio, stakeholders can gain valuable insights into a company's financial risk, creditworthiness, and comparison to industry norms. The importance of this ratio goes beyond mere numbers; it provides a clearer picture of a company's ability to sustain operations amid economic fluctuations. 

A high debt-to-EBITDA ratio can signal increased vulnerability, while consistently monitoring this metric can help track debt trends and overall financial stability. However, relying solely on the debt-to-EBITDA ratio may not paint the complete picture. It's essential to consider it alongside other financial metrics to evaluate a company's performance comprehensively. Combining various metrics can yield more nuanced insights and help make informed decisions.

If you're an entrepreneur aiming to master financial metrics like the debt-to-EBITDA ratio, joining Recur Club can be a game-changer. As India’s largest debt marketplace, Recur Club offers debt capital tailored to finance enthusiasts, supporting over 700 startups and SMEs. You'll gain practical insights into leveraging the debt-to-EBITDA ratio to make informed investment decisions, enhance your financial strategy, and confidently navigate complex analyses.