What is Debt- to EBITDA Ratio and Why Is It Important for Self Employed Borrowers?
- by HOME ONLINE
- on 08/02/2017
- at 12:17 PM
In order for banks and financial institutes to approve the loan for you, they try to assess the best loan that you can bear according to your financial capability. The analysis also includes your financial background, your turnover and whether you will be able to repay back the loan in the agreed tenure or not.
To analysis this, the lender will have to calculate a certain ratio. The borrower is expected to meet the fixed percentage of the ration for the loan to be granted.
The ratio is Debt- to- EBITDA ratio.
What is it?
Debt- to- EBITDA (earnings before interest taxes depreciation and amortisation) is the ratio that is used to compare the financial borrowings and the earnings before interest, taxes, depreciation and amortisation. This is the most common tool that the banks and financial institutes use to estimate the business valuation. It is used to analyse the financial stability and the liquidity position of the borrower’s company. It helps in finding out whether the borrower will be able to pay off the loan amount.
Why is it important?
A lower debt- to- EBITDA is a positive indicator and it means that the company has sufficient funds to pay off the loan. Higher debt- to – EBITDA ratio signifies that the company is heavily leveraged and it may find it difficult to pay off the loan, which is a concern for the banks and financial institutes. High debt- to- EBITDA ratio also means that the company has low credit score. However, the low debt- to- EBITDA ratio will signify that the borrower has a good credit score and can take and repay back the loan.
The ratio also gives the lenders and estimate idea of the time that will be required by the borrower to pay off all the debts excluding the factors like interest, taxes, depreciation and amortisation.
For example, assume that a person X runs a company ABC Ltd. The company has Rs 10 lakhs in debt and Rs 1 lakh in EBITDA in 2014. The debt- to- EBITDA ratio in 2014 is 10. In two years, the borrower pays off half the loan amount and raised its EBITDA to Rs 5 lakhs which reduced the debt- to- EBITDA ratio to 1.
The reducing ration implies that the borrower is paying off the debt and it is a good indicator.
Banks norms and limits:
Banks and financial institutes consider the ratio less than 3 as the safer investment zone while the ratio higher than 4-5 is a red light for them. The companies with higher debt- to- EBITDA is less likely to get the loan approved.