What Is the EBITDA-to-Interest Coverage Ratio?
The EBITDA-to-interest coverage ratio is a financial ratio that is used to assess a company's financial durability by examining whether it is at least profitable enough to pay off its interest expenses using its pre-tax income. Specifically it looks to see what proportion of earnings before interest, taxes, depreciation, and amortization (EBITDA), can be used for this purpose.
The EBITDA-to-interest coverage ratio is also known simply as as EBITDA coverage. The main difference between EBITDA coverage and the interest coverage ratio, is that the latter uses earnings before income and taxes (EBIT), rather than the more encompassing EBITDA.
- The EBITDA-to-interest coverage ratio, or EBITDA coverage, is used to see how easily a firm can pay the interest on its outstanding debt.
- The formula divides earnings before interest, taxes, depreciation, and amortization by total interest payments, making it more inclusive than the standard interest coverage ratio.
- A higher coverage ratio is better, although the ideal ratio may vary by industry.
The Formula For the EBITDA-to-Interest Coverage Ratio Is:
Understanding the EBITDA-to-Interest Coverage Ratio
The EBITDA-to-interest coverage 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. A ratio greater than 1 indicates that the company has more than enough interest coverage to pay off its interest expenses.
While the 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 (earnings before interest, tax, depreciation and amortization) 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 since 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 interest payments + lease payments)
Interest coverage ratio, which is EBIT / interest expenses.
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 also reports depreciation of $50,000 and interest expenses of $120,000. 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 (earnings before interest and tax) and adding back 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) / ($120,000 + $100,000)
- = $730,000 / $220,000
- = 3.32