How to really judge a company's debt

2026-07-28 · By Lubin Danilo, founder of Lubin Investment

To judge whether a company's debt is too heavy, you can compare it to accounting-style broad earnings (EBITDA, Wall Street's preferred measure) or to actual cash generated (free cash flow, my measure). The two sometimes tell opposite stories about the same company, because one ignores real investment spending and the other does not. Here is how I choose, with real numbers.

Two ways to judge whether debt is too heavy

When you want to know if a company is too indebted, the most useful question is not 'how much does it owe?' but 'how long would it take to repay this debt with the cash it generates each year?'. To answer that, you divide net debt (financial debt minus available cash) by some measure of the company's yearly cash-generating power. And that is where two schools of thought clash.

Wall Street, in the vast majority of analyst reports and bank loan covenants, uses EBITDA: earnings before interest, taxes, depreciation, and amortization. It is a measure of gross operating profit, before subtracting the non-cash charges tied to equipment wear. My method, instead, systematically uses free cash flow (FCF): the money that truly remains in the company's coffers after ALL bills are paid, including equipment investment (capex). On paper, these are two ways of measuring the same thing. In practice, they can tell opposite stories.

Why EBITDA can hide the real burden of debt

The problem with EBITDA is that it adds back depreciation, meaning the portion of equipment cost (factories, machines, networks, planes) spread over several accounting years. This add-back starts from a simple idea: depreciation is not an immediate cash outflow, so it gets ignored. The problem is that for a company that must continually reinvest in its equipment to stay competitive (a telecom building fiber, an industrial firm renewing its plants), the real cash outlay for that investment (capex) is often higher than accounting depreciation suggests, especially during periods of construction cost inflation. EBITDA completely ignores this capex. The result: a company investing heavily can show a healthy EBITDA while its free cash flow is squeezed by very real investment spending.

Take a concrete, publicly documented case: a major US telecom operator (already cited in my article on the debt filter in my method as a typical case of structural debt) is guiding for annual investment of $23 to $24 billion over the coming years, to fund fiber and 5G rollout, while its expected free cash flow runs around $18 to $21 billion over the same period. Its EBITDA, meanwhile, keeps growing at a 3-4% yearly pace, a figure that looks perfectly healthy in isolation. But a net-debt-to-EBITDA ratio will never see that $23-24 billion of annual investment: it looks at a broad earnings figure that never subtracted this expense. A net-debt-to-free-cash-flow ratio, by contrast, directly captures the effect of this massive investment on the money actually left to repay debt, pay dividends, or buy back shares.

My method in practice: a real example with IBM

IBM, whose second-quarter 2026 results I already analyzed, ended 2025 with total debt of $61.3 billion and annual free cash flow of $14.7 billion. The net-debt-to-free-cash-flow ratio I use comes out at just under 5 years: it would take IBM roughly five years of current cash generation to repay its entire debt, if it did nothing else with it. That is above the 3-year threshold I prefer to see for a classic industrial company, which penalizes IBM in my quality screen, even though the company otherwise remains profitable and generates solid free cash flow. This debt is largely explained by decades of acquisitions (notably the $34 billion Red Hat purchase in 2019) and pension obligations inherited from its status as a historic American tech employer, not by immediate operational fragility. But my screen applies the same rule to every company: debt is judged by the real cash it generates, not by its history or its excuses.

The trap to avoid: neither ratio is always right

It would be tempting to conclude that free cash flow is always right and EBITDA always wrong. It is not that simple. A company in a deliberate growth-investment phase (building new plants to capture surging demand, for instance) will see its debt-to-FCF ratio temporarily inflated by growth capex, not maintenance capex: a signal that looks worrying in the short term may actually foreshadow future acceleration, as I explain in my article on the difference between maintenance and growth capex. The right reflex, then, is not to pick a single ratio and apply it blindly, but to understand WHY the two ratios diverge for a given company: is it one-off growth capex (worth watching, not panicking about) or structurally high maintenance capex that continuously erodes repayment capacity (a genuine warning sign)?

Two ways to judge debt: net debt/EBITDA (the Wall Street standard, ignores equipment investment) and net debt/free cash flow (my method, captures real investment spending).
EBITDA adds back accounting depreciation to earnings but ignores capex actually spent: a company investing heavily can show a healthy EBITDA while its free cash flow is squeezed.
Real example: IBM carries $61.3B of debt against $14.7B of annual FCF, close to 5 years of repayment under my ratio, versus the 3-year threshold I prefer. A major US telecom invests $23-24B/year while its FCF runs around $18-21B, even as its EBITDA keeps growing 3-4%/year.
The right reflex: don't pick one ratio blindly, but understand whether the gap between the two comes from one-off growth capex or structurally high maintenance capex.

FAQ

What is the difference between EBITDA and free cash flow?

EBITDA is earnings before interest, taxes, depreciation, and amortization: a measure of gross operating profit that ignores equipment investment. Free cash flow is the money truly left after ALL expenses, including that investment. That is why the two can diverge sharply for a company that invests heavily.

Why does Wall Street mostly use EBITDA to judge debt?

Because it is a standardized measure, easy to compare across companies and sectors, and often used in legacy bank loan covenants. But it has a blind spot: it never subtracts capex, the money actually spent to maintain or grow equipment.

Why does IBM's debt penalize its score in your method?

Because its $61.3 billion of debt relative to its $14.7 billion of annual free cash flow represents close to 5 years of repayment, above the 3-year threshold I prefer. This debt mostly comes from past acquisitions (Red Hat) and inherited pension obligations, not immediate operational fragility, but my screen applies the same rule to every company.

Is a high debt/FCF ratio always a bad signal?

No. If it comes from one-off growth investment (new plants to capture rising demand), it is temporary and can foreshadow future acceleration. If it comes from structurally high maintenance capex that continuously erodes repayment capacity, it is a genuine warning sign. You need to understand the cause before concluding.

About the author

Written by Lubin Danilo, founder of Lubin Investment. A self-taught individual investor, I find fundamental analysis fascinating, and it has delivered excellent results. For three years now, my performance has beaten the S&P 500. But analyzing every stock took too much time: sites with incomplete data, calculation methods and criteria never aligned with mine. And spotting the best stocks was just as time-consuming, even with my own well-defined checklist. So I put my software development background to work to build this software, base my investment strategy on its results, and share it with people who share the same passion as me. It judges a company's quality and its price separately, using criteria drawn from the financial literature (Warren Buffett, Michael Mauboussin, Aswath Damodaran).