Why the Debt/EBITDA Ratio is Crucial to Junk Bonds

A company's debt/EBITDA ratio measures its ability to pay off its incurred debt, which is critical for junk bonds. It is a useful tool for investors trying to estimate how likely an issuer is to meet its obligations. EBITDA stands for earnings before interest, taxes, depreciation, and amortization, so the debt/EBITDA ratio can provide a different picture than earnings alone.

The Debt/EBITDA Ratio and Credit Ratings

Debt/EBITDA is one of the leading financial metrics used by credit rating agencies to determine an issuer's default risk. The most influential credit rating agencies are Standard & Poor's, Moody's, and Fitch Ratings. When an issuer's debt/EBITDA ratio is high, agencies tend to downgrade a company's ratings because this signals potential difficulty making payments on debts. On the other hand, a low debt/EBITDA ratio indicates the opposite. A firm with a low debt/EBITDA ratio should easily be able to make good on its debts, so it is likely to receive a higher credit rating.

The debt/EBITDA ratio helps to illustrate just how direct the link is between an issuer's debt load and its credit rating. Junk bonds are fixed income securities from issuers with a credit rating of "BB" or lower from S&P or "Ba" or lower from Moody's. These bonds are called junk precisely because of their higher default risk and lower credit ratings. This higher default risk stands in direct correlation with the level of debt relative to the corporation's earnings before interest, taxes, depreciation, and amortization.

Investment Grade Bonds

The higher a company's debt/EBITDA ratio, the more indebted it is. Agencies will usually only rate a company's bonds as investment grade if the debt/EBITDA ratio is less than two. Other companies must compensate for their higher ratios with higher yields to pay investors to take on the additional risk. Note that the critical ratio varies significantly between industries. For example, utility company bonds may be rated as investment grade with higher debt/EBITDA ratios because of the stability of their industry.

Junk Bonds

The net debt/EBITDA ratio is considered to be even more significant for investors in high-yield corporate bonds. Net debt measures leverage, which is calculated as the issuer's liabilities minus liquid assets. The net debt/EBITDA ratio indicates the number of years it would take an issuer to pay off all debt. That interpretation assumes that the company's EBITDA remains constant. When a company has more cash on hand than it does debt, the ratio can even be negative.

The net debt/EBITDA ratio is also a popular measurement with investment analysts who want to determine if a company can safely increase its debt. Investors typically avoid anything with a ratio higher than four or five. Such high ratios indicate the issuer is unlikely to be able to handle the additional debt burden. An extremely high net debt/EBITDA ratio means that a firm can no longer access credit markets, even at high-yield junk bond rates.

Limitations of the Debt/EBITDA Ratio

Both debt/EBITDA ratios mentioned above are important for investors and analysts in the junk bond market, but they do have some limitations. Contrary to common misconceptions, EBITDA does not represent cash earnings. It is an excellent tool for evaluating profitability, but it is not the same as a company's cash flow. One reason is that EBITDA leaves out potential costs that can be significant. These costs include working capital and replacing broken or outdated tangible assets. Because it does not account for these factors, EBITDA can be manipulated to make a company's earnings outlook appear more favorable. Therefore, investors should use EBITDA along with other performance metrics to form an accurate picture of a company's financial situation.