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What Is the EBITDA-to-Interest Coverage Ratio?
The EBITDA-to-interest coverage ratio is a financial metric that shows how easily a company can pay its interest using its pre-tax income. Unlike standard interest coverage, which uses earnings before interest and taxes (EBIT), this ratio uses earnings before interest, taxes, depreciation, and amortization (EBITDA) to focus on cash earnings. A higher ratio indicates a stronger ability to meet interest payments. Leveraged buyout bankers used this ratio to check a company’s short-term debt-paying ability.
- The EBITDA-to-interest coverage ratio assesses a company’s ability to pay interest using pre-tax income.
- EBITDA coverage uses earnings before interest, taxes, depreciation, and amortization, making it more inclusive than standard interest coverage.
- A ratio greater than 1 signals a company can cover its interest expenses.
- The EBITDA-to-interest coverage ratio originated with leveraged buyout bankers to evaluate debt servicing ability.
- A higher coverage ratio is generally better, though ideal ratios vary across industries.
The Formula For the EBITDA-to-Interest Coverage Ratio Is:
How to Interpret the EBITDA-to-Interest Coverage Ratio
Leveraged buyout bankers first widely used this ratio to quickly assess if a restructured company can meet its short-term debt.
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. Since EBITDA excludes depreciation expenses, a ratio of 1.25 may not reliably indicate financial strength.
Calculating the EBITDA-to-Interest Coverage Ratio: A Step-by-Step Example
1. Gather the essential financial figures: Identify the company’s sales revenue, salary expenses, utility costs, lease payments, depreciation, and interest expenses.
2. Calculate EBIT: Subtract operating expenses and depreciation from sales revenue. Use the following formula: EBIT = Revenues – (Salary Expenses) + Utilities + Lease Payments) − Depreciation. For example: EBIT = $1,000,000 – ($250,000 + $20,000 + $100,000) – $50,000 or $580,000.
3. Calculate EBITDA: Add back depreciation and amortization to EBIT. Use the formula: EBITDA = EBIT + Depreciation. For example: EBITDA = $580,000 + $50,000 or $630,000.
4. Compute the EBITDA-to-interest coverage ratio, including lease payments: Use the formula: EBITDA-to-Interest Coverage Ratio = (EBITDA + Lease Payments} ÷ (Interest + Lease Payments). For example: EBITDA-to-interest coverage ratio = ($630,000 + $100,000) ÷ ($120,000 + $100,000) or 3.32.
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