What Is the EBITDA-to-Interest Coverage Ratio?
Let me explain the EBITDA-to-interest coverage ratio directly to you. It's a financial ratio that helps assess a company's financial durability by checking if it's profitable enough to handle its interest expenses using pre-tax income. Specifically, it examines what portion of earnings before interest, taxes, depreciation, and amortization—EBITDA—can cover those costs.
You might also hear it called simply EBITDA coverage. The key difference from the standard interest coverage ratio is that this one uses EBITDA, which is broader than just earnings before interest and taxes, or EBIT.
Understanding the EBITDA-to-Interest Coverage Ratio
This ratio, or EBITDA coverage, shows how easily a firm can pay interest on its outstanding debt. You calculate it by dividing EBITDA by total interest payments, which makes it more inclusive than the standard version. Remember, a higher ratio is generally better, but the ideal level can vary depending on the industry.
Leveraged buyout bankers were the first to widely use this ratio as a quick check to see if a restructured company could handle its short-term debt. If the ratio is greater than 1, it means the company has more than enough to cover its interest expenses.
That said, while it's a straightforward way to gauge interest coverage, it has limitations because EBITDA serves as a proxy for various financial aspects. For instance, if a company has a ratio of 1.25, it might seem okay, but if it needs to spend heavily on replacing old equipment—which EBITDA doesn't account for—that ratio might not truly reflect financial durability.
The Formula for the EBITDA-to-Interest Coverage Ratio
Here's the formula you need: EBITDA-to-interest coverage = (EBITDA + lease payments) / (loan interest payments + lease payments). There's also the basic interest coverage ratio, which is EBIT / interest expenses, but we're focusing on the EBITDA version here.
EBITDA-to-Interest Coverage Ratio Calculation and Example
Analysts sometimes debate which of the two similar formulas to use, depending on the company. I'll stick to the one that includes lease payments for this explanation.
Take this example: A company has sales revenue of $1,000,000, salary expenses of $250,000, utilities at $20,000, lease payments of $100,000, depreciation of $50,000, and interest expenses of $120,000. First, calculate EBITDA. Start with EBIT: revenues minus operating expenses minus depreciation, which is $1,000,000 - ($250,000 + $20,000 + $100,000) - $50,000 = $580,000. Then, EBITDA = EBIT + depreciation + amortization = $580,000 + $50,000 + $0 = $630,000.
Now, plug into the formula: ($630,000 + $100,000) / ($120,000 + $100,000) = $730,000 / $220,000 = 3.32. So, the ratio is 3.32, indicating strong coverage.
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