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Author: TMFSandman Big red star, 1000 posts Feste Award Nominee! Old School Fool Coverage Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 2209  
Subject: Re: Net debt/EBITDA Net debt/Equity Date: 4/1/2011 5:29 PM
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I don't have a great answer other than everyone has their personal favorite measures when looking at a company. Net debt/EBITDA and net debt/equity measure debt in relation to two different things, and I think it's actually important to look at both.

Net debt/EBITDA is a solvency measure. The higher the number, the harder it is for a company to meet its debt obligations strictly out of earnings. This ratio is frequently used by banks when lending to businesses. Typically you'll see in bank loan covenants that a company's debt/EBITDA ratio can't go above around 5 or so.

Net debt/equity is a capital structure ratio that looks at how the company is financed. Instead of telling you how easily pre-tax earnings can cover debt repayment it's telling you how levered the company's equity base is relative to its total assets. If the ratio is significantly above 60% or so you have to think about who has the most say in the company's affairs. A heavily-leveraged company will be answerable to bondholders in ways a company with less leverage won't be. And if a company depends on heavy leverage to grow you have to be pretty confident as a prospective owner of the company that you will have good access to capital markets when the time comes to either roll that debt over into new debt or to take on even more debt.

Both ratios are important and what is acceptable in one industry wouldn't be in another. A regulated utility selling power at the retail level and utilizing a cost plus-a-margin revenue model usually takes on a fair amount of debt relative to earnings and its equity base when compared to the average business. It can do this since its earnings are so steady. Compare that to a car manufacturer, which is in a highly cyclical business. The utility's net debt/EBITDA ratio is likely pretty stable while the car company's likely bounces all over the place.

As well, if one of the ratios is in great shape the other ratio may be able to get a little higher than average. For example, if you have very high, very steady earnings, (i.e. a great debt/EBITDA ratio) you can probably safely take on more debt relative to equity than the average business. On the other hand, maybe you have very little debt to equity, say 10%. Your earnings are very volatile and one year your debt/EBITDA ratio is say, 10. Normally this would be considered very bad but in your case, the debt is likely very easily covered by cash on the balance sheet or other assets, if it absolutely needed to be paid back in the current year when your earnings stink.

Another great debt-related data point to look up is when the debt is due. Neither of the above ratios tell you this. A company may have a net debt/EBITDA ratio of 2 and a debt/equity ratio of 30%, but surprise! All of the debt is due in 1.5 years. Probably not an issue as long as the capital markets are open and the company is doing well, as it can then likely just roll the debt over into new debt or pay down the debt with cash from the balance sheet,

But what if the company couldn't roll over that debt and doesn't have the cash? Then they'd have to sell off some assets or sell more equity to raise the funds. But that requires finding a willing buyer, and what if the company couldn't find one? Now the company is in trouble, and this is just the situation that some companies found themselves in during the 2008-2009 financial crisis.


Mike
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