The EBITDA coverage ratio is one of several ratios that is used to evaluate a company’s financial strength to meet its debt obligations. This ratio is one of the finest metrics to analyze a company’s financial durability.
The EBITDA coverage considers the cash flows of a company rather than operating profit. Thus, it offers a realistic picture of the company in terms of solvency.
Let us discuss the EBITDA coverage and how to calculate it with an example.
What is EBITDA?
The word EBITDA is an acronym and it stands for Earnings before Interest, Tax, Depreciation, and Amortization.
It excludes some costs such as interest and tax and adds back depreciation and amortization. Thus, it aims to provide a more realistic picture of the profitability of a business.
Using EBITDA in an interest coverage ratio offers a clearer picture of a company’s ability to repay its obligations from its cash flows.
How to Calculate the EBITDA Coverage Ratio?
The company first calculates the EBITDA figure. The figure is calculated by adding back the depreciation and amortization to the operating income of the company.
There are two ways that you can calculate the EBITDA coverage ratio. The first method is to add lease payments to the EBITDA figure and divide it by the sum of debt payments and lease payments.
The second method is to simply divide the EBITDA by the total debt obligations of a company.
EBTIDA Coverage Ratio = EBITDA / Total Interest Payments
EBITDA Coverage Ratio = (EBITDA + Lease Payments) ÷ (Debt Payments + Lease Payments)
The use of lease payments is for the minimum lease payments for a company. Similarly, the EBITDA figure can be taken from the operating income plus adding back the depreciation/amortization costs.
An EBITDA coverage ratio above 1 means the company can cover its debt obligations from its free cash flows. A ratio below 1 would mean that the company cannot meet its debt obligations through its internal resources.
An important point to remember is that a low ratio is not always bad. For instance, established companies are often highly leveraged and come with a low EBITDA coverage ratio. However, these companies have significant assets pledged as collateral and they generate sufficient cash flows to meet their debt obligations.
Suppose a company ABC reported an operating income of $ 1,200,000. Its current depreciation costs are $ 50,000 and amortization costs are $ 30,000.
The company has debt interest payments of $ 300,000 and lease payments of $ 250,000.
We can calculate this ratio with the help of both formulae stated above.
First, we need to calculate the EBITDA.
EBITDA = Operating Income + Depreciation + Amortization
EBITDA = $ 1,200,000 + $ 50,000 + $ 30,000 = $ 1,280,000.
EBITDA Coverage Ratio = EBITDA / Total Interest Payments
EBITDA = $ 1,280,000 / ($ 550,000) = 2.327
EBITDA Coverage Ratio = (EBITDA + Lease payments) ÷ (debt payments + lease payments)
EBITDA Coverage Ratio = (1,280,000 + 250,000) ÷ (300,000 + 250,000)
Therefore, EBITDA Coverage Ratio = 1,830,000 ÷ 550,000 = 3.327
As we can see both methods provide different ratios. The choice of choosing one over the other depends on the accounting policies of the company. However, for consistency, the company must use the same method for comprehensive analysis over the long run.
How EBTIDA Coverage Ratio is different from the Interest Coverage Ratio?
The EBITDA coverage ratio is a refined formula than the conventional interest coverage ratio.
The interest coverage ratio considers the operating income of the company before depreciation and amortization costs. The argument is that these costs are non-cash items. Thus, these costs should be excluded from interest coverage analysis.
The interest coverage ratio can be calculated as:
Interest Coverage Ratio = EBIT / Total Interest Expense
If we consider the figures from our example above, then:
Interest Coverage Ratio = $ 1,200,000 / $ 550,000 = 2.18
Since the denominator for both calculations of EBITDA and the Interest coverage ratio is the same but the numerator differs, both will offer different ratios.
The numerator of the EBITDA will be greater; thus, it will give a higher ratio than the interest coverage that excludes the depreciation and amortization costs.
Again, the choice of using one of these two depends on the accounting policies of the company. Both figures provide useful measures to analysts.
Importance of EBITDA Coverage Ratio
This ratio is a simple method to analyze a company’s financial health. Analysts and creditors can use this ratio to analyze whether the company is capable of paying its interest on debt or not.
The EBITDA offers valuable information about a company’s cash flows as well. Creditors can dig deeper to evaluate whether the company is generating sufficient cash flows to meet its interest payments.
This ratio is a simple and widely used method. Thus, it can be used by investors, creditors, and shareholders alike. However, there is no standard form to decide on what is a good EBITDA coverage ratio.
Limitations of EBITDA Coverage Ratio
Like other ratio analyses, the EBITDA coverage ratio has its limitations as well.
First, a standalone EBITDA coverage ratio is not sufficient to analyze the ability of a company to meet its financial debt obligations.
Second, the ratio depends largely on the accounting figures of EBIT or EBITDA that does not always represent the actual cash flows of the company.
Third, the company managers can manipulate the ratios through a change in the depreciation and amortization rules.
Analysts must use this ratio of companies within the same industry and similar sizes for comparisons. Moreover, a trend analysis of historic indicators of the ratio should be used for comprehensive analysis.
The EBITDA coverage ratio is a useful measure to assess a company’s ability to meet its interest obligations. Creditors can use this ratio to evaluate a company’s cash flows that can be used to pay interest payments.