What is the 'EBITDA-To-Interest Coverage Ratio'
The EBITDA-to-interest coverage ratio is a ratio that is used to assess a company's financial durability by examining whether it is at least profitably enough to pay off its interest expenses. A ratio greater than 1 indicates that the company has more than enough interest coverage to pay off its interest expenses. This ratio is also known as EBITDA coverage.
The ratio is calculated as follows:
BREAKING DOWN 'EBITDA-To-Interest Coverage Ratio'This ratio was first widely used by leveraged buyout bankers, who would use it as a first screen to determine whether a newly restructured company would be able to service its short-term debt obligations. While this ratio is a very easy way to assess whether a company can cover its interest-related expenses, the applications of this ratio are also limited by the relevance of using EBITDA as a proxy for various financial figures. For example, suppose that a company has an EBITDA-to-interest coverage ratio of 1.25; this may not mean that it would be able to cover its interest payments, because the company might need to spend a large portion of its profits on replacing old equipment. Because EBITDA does not account for depreciation-related expenses, a ratio of 1.25 might not be a definitive indicator of financial durability.
EBITDA-To-Interest Coverage Ratio Calculation and Example
There are two formulas used for the EBITDA-to-interest coverage ratio that differ slightly. Analysts may differ in opinion on which one is more applicable to use depending on the company being analyzed. They are as follows:
EBITDA-to-interest coverage = (EBITDA + lease payments) / (loan payments + lease payments)
EBITDA / interest expenses, which is related to the EBIT / interest expense ratio.
As an example, consider the following. A company reports sales revenue of $1,000,000. Salary expenses are reported as $250,000, while utilities are reported as $20,000. Lease payments are $100,000. The company reports depreciation of $50,000 and interest expenses of $100,000. To calculate the EBITDA-to-interest coverage ratio, first an analyst needs to calculate the EBITDA. EBITDA is calculated by taking the company's EBIT ratio and adding back in the depreciation and amortization amounts.
In the above example, the company's EBIT and EBITDA are calculated as:
EBIT = revenues - operating expenses - depreciation = $1,000,000 - ($250,000 + $20,000 + $100,000) - $50,000 = $580,000
EBITDA = EBIT + depreciation + amortization = $580,000 + $50,000 + $0 = $630,000
Next, using the formula for EBITDA-to-interest coverage that includes the lease payments term, the company's EBITDA-to-interest coverage ratio is:
EBITDA-to-interest coverage = ($630,000 + $100,000) / ($100,000 + $100,000) = 3.65