multiple compares total debt to one year’s worth of Earnings before Interest,
Taxes, Depreciation, and Amortization (or “EBITDA”). EBITDA is, therefore, a proxy for funds
available to service the debt. The
resulting multiple indicates how much EBITDA (or approximately how many periods)
it would take to retire the debt with EBITDA.
This ratio is, therefore, a measure of “cash flow leverage”.
a lower multiple indicates less leverage and lower risk. Keep in mind that you are comparing a balance
sheet item to an income statement measure with this ratio. This can be problematic if the debt balance
at the end of a given period is unusually high or low or if EBITDA is measured
in only a partial year.
Note that total interest-bearing debt should comprise the numerator, and it may also be appropriate to subtract cash and cash equivalents from total debt to construct a more meaningful ratio.
discussed in the previous post, an analyst may want to exclude intangible
assets from the calculation of net equity when constructing a debt to worth
ratio. You subtract net intangible
assets from the denominator to make this adjustment. This results in a higher (but more
conservative and maybe also a more accurate) measurement of leverage.
described earlier, the debt to worth ratio represents capital contributed by
creditors against capital contributed by owners. If you examine the Smith Heating and Cooling,
Inc. balance sheet, you will see that some of the company’s debt is actually
due to a company owner. An analyst might
consider this to be a form of owner’s equity and alter the ratio accordingly to
take a truer picture of leverage.
To do this,
you would subtract loans from owners from total liabilities in the numerator
and add the same amount to equity in the denominator. Only “senior debt” or the bank debt in the
first position in the event of liquidation is actually included as liabilities
in this case.
these adjustments results in a “senior debt to tangible net worth plus
subordinated debt” ratio. For Smith
Heating and Cooling, Inc., this ratio is $9.44 to 1, which is still pretty
high. The company is, indeed, highly
leveraged. But, the ratio is more
meaningful in this case, and this number can be compared to an industry average
to see how it measures up.