Obviously, 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.
Saturday, November 24, 2018
This 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”.
As 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.
Also 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.
Making 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.