Skip to content
All library documents

Why Debt-to-EBITDA Has No Universal High-Leverage Threshold

Article Quant Q&A · Author: hannes101
Read the original

Summary

The document considers whether a debt-to-EBITDA ratio has standard categories for high and low leverage. Its answer is that interpretation is largely contextual, varying with country and sector. It gives an example from distressed private equity in which net debt above seven times EBITDA was treated as highly leveraged, while emphasizing that this was an informal rule of thumb rather than a universal cutoff.

A ratio alone says little about a company’s ability to service debt or its risk to creditors. Cash-flow stability and collateral can make a firm with a higher ratio safer than one with a lower ratio. The document also distinguishes net debt from gross debt because net debt subtracts cash. For rigorous analysis, it points toward leverage relative to firm value and cash flow, while noting that academic models often do not focus on net-debt-to-EBITDA categories. Cross-firm comparisons therefore require attention to industry and underlying business risk.

Key ideas

  • Debt-to-EBITDA thresholds are subjective and depend on sector and country.
  • A rule-of-thumb cutoff does not provide a universal measure of financial health.
  • Cash-flow stability and collateral affect how risky a given leverage ratio is.
  • Net debt subtracts cash, so it differs from gross debt.
  • Leverage analysis can also compare debt with company value and cash flow.

Tags

EquitiesRisk managementStatistics
Full text
# Objective measure of highly leveraged firms using Debt-to-EBITDA ratio


# Objective measure of highly leveraged firms using Debt-to-EBITDA ratio












I am looking for some kind of guidance what is generally considered a high or low ratio of Debt-to-Earnings before interest, tax, depreciations and amortisations (EBITDA). In a recent article by The economist - "America's companies have binged on debt; a reckoning looms" [1] from March 8th 2018, a highly leverage company is defined as having a ratio greater than 5.

I would like to find some academic literature or analysis on the different categories which might exist for this ratio. Or is it just a subjective measure, probably relative to some industries known for low levels of leverage.

[1] https://www.economist.com/news/business/21738397-total-debt-american-non-financial-corporations-percentage-gdp-has-reached

## Answer by phdstudent (score 2)

https://quant.stackexchange.com/a/39019

It is mainly subjective, depends on country and sector. E.g. when I worked in private equity in a distressed fund a highly levered company was a company with a net-debt to EBITDA ratio > 7.0.

Those are back of the envelope numbers. They actually do not tell you much about the health of the company nor its risk. A company with 7.0x net-debt to EBITDA ratio might be safer for debtholders than a company with 3.0x net-debt to EBITDA ratio if it has more stable cashflows or more collateral.

In any case, the article you mention looks at net debt to EBITDA this is important as it subtracts the cash the company has.

Proper academic work would will look mainly at leverage to value ratios and leverage to cashflow. Not really to net-debt as most models assume there is no role for cash-holdings (there are few exceptions to this). Still you won't find any study with a clear cut in terms of categories for net debt to ebitda ratios. Those are mainly subjective and meant to be used mostly in cross firm/industry comparisons just as in the economist article you mention.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.