The more stable and consistent a company’s earnings, the more likely you are to feel comfortable with a large net debt balance. If a company’s earnings history is volatile, you will likely want to identify a capital structure that allows you to pay down debt quickly. Overall the objective should be to have your cash position grow relative to the amount of debt on the balance sheet. If a company’s net debt position is negative, then you know that you can most likely meet all debt obligations immediately (because you have more cash than debt).
From this point forward the ratios mentioned are likely to be found in credit term sheets and credit agreements. In addition to the items listed, it is not uncommon for creditors to require that a company maintain minimum levels of liquidity and EBITDA.
Moving beyond cash on the balance sheet, the most frequently used measure of profitability is EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). The ratio of a company’s EBITDA in any period compared against the total sum of debt on the balance sheet is known as the debt-to-EBITDA ratio.
EBITDA provides a proxy for cash flow that facilitates back-of-the-envelope calculations surrounding the amount of leverage a company can comfortably assume. For example, if you knew that a company’s total-debt-to-EBITDA ratio was 2.0x you would likely comfortably assume that the company can easily meet its debt obligations. But if you saw that a company’s total-debt-to-EBITDA ratio was 5.0x it might be reason for concern. Absent some additional information, you really do not have a way to gauge if the company’s capital structure is appropriate.
Consider for example, that you are comparing leverage ratios for a SAAS business and an asset-heavy transportation business. The former would likely have minimal capital expenditures, but it would not be uncommon if the asset-heavy transportation business had capital expenditures equivalent to roughly 50% of EBITDA. These are very different cash needs, and the discrepancy highlights the need to go beyond back-of-the-envelope math.
For some additional precision, most credit agreements will include at least two financial covenants: (1) a measure of debt to EBITDA, and (2) the Fixed Charge Coverage Ratio.