Question

Why would the amount of debt/EBITDA be an important ratio when examining the problem of high debt, particularly with respect to the leveraged loans? Why might debt/equity or debt/assets be less appropriate? Are there other ratios that would also be helpful to potential investors when examining a company’s debt situation or prior to investing in this debt?

Answer 1

The debt to EBITDA ratio is a measure to ascertain the capability of a firm to produce enough income from its operations to pay back its debt. If debt is compared with any other measure of income like net profit and gross profit, it will not reflect the true capability of the company to pay back its debt. The money generated from operations is what matters and EBITDA is also known as operating income of the company. A comparison of EBITDA with debt will show the strength in company's operations for repayment of its debt burden, while a measure of debt to equity only gives a idea about how much debt the owners or the equity holders of the company has taken in comparison to the equity of the firm. A EBITDA to debt ratio can inform a investor about the liquidity position of the company to pay back its debt, whether enough money is generated or not etc. while debt to equity and debt to assets is useful for investors to judge the solvency of the company.

Some other ratios which can be important for a investor to analyze the overall debt position of the firm includes debt service Coverage ratio, under which the operating income of the company will be divided by the annual loan payments of the company to ascertain the strength of company's operations to pay its annual loan installments. Yet another ratio can be interest coverage ration, under which the EBIT of the company is divided by the amount of interest paid on loan by the company annually. This will allow investor to have an idea about how much interest company is paying on its debt as compared to its business operations earnings.