3-6-3 Rule

finance a la shmoop what is the debt to EBITDA ratio alright people well

anytime you see that to in there a pretty good chance we're dealing with a [Person writes ratio on chalkboard]

ratio and yeah this one's a ratio that compares what a company owes in debt to

its EBITDA or earnings before interest taxes depreciation and amortization

otherwise lovingly known on Wall Street as cash flow like the cash it produces [Cash falls from sky]

alright well the numbers used by bankers and investors to see how leveraged is a

company is and evaluate its creditworthiness the higher the number

the more likely it is that a company will struggle to pay up its debt.. Well,

let's use a couple of practical examples here, a demo;

if your friend Deb wants

to borrow five grand from you maybe Deb just doesn't want her pops to

know she you know dented the car she's not the best driver in the world and

Deb's a two on the friend reliability scale like you totally trust her and [Deb moving side to side on reliability scale]

she's a lawyer and makes hundreds of thousands of dollars a year suing people

for stuff all right well after living expenses she has cash flow personally of

some fifty grand a year that she socks away in a mattress you know what she [Deb places cash under mattress]

sleeps on so you'd go ahead and make the loan to Deborah and you'd have no doubt

that she has the dough to pay you back your five grand the debt to EBITDA in

this situation five grand over 50 grand or one to ten or 0.1 very low debt to

EBITDA ratio there very safe bet she'll pay you back your five grand

well this logic applies to loaning companies money as well the five grand [Man discussing loans outside Amazon building]

in debt is quote money good unquote and you don't lose sleep over loaning them

that money if they have good credit and low debt to EBITDA doubt ratios right they

have more than enough cash flow to cover that debt well so then what's bad debt

to EBITDA ratio like what does that look like well it's when you have debt

of more than three or four five times cash flow some companies go even higher [Bad debt-to-EBITDA ratio example]

so if whatever dot-com has 50 million dollars in cash flow but three hundred

million dollars in debt that's a really high debt to EBITDA ratio of three

hundred over fifty or six to one or you just say

6x if that debt costs a 8% a year to rent well then the total cost just to pay

interest is 24 mil or almost half of all the company's cash flow for the entire

company and remember they got to be paying down the principal as they go [Whatever.com's cash flow debt]

along as well so it's a huge percentage of their cash flow just goes to the bank

should whatever com stumble and maybe you don't know interest rates go up as

well well then things could get ugly really fast and yes even uglier than [Deb driving a car in a storm]

this so yeah you want low debt to EBITDA ratios not high ones unless you're a

real dice roller there [Debt laid in hospital bed]