What is the EBITDA Coverage Ratio
What is the EBITDA Coverage Ratio
The EBITDA coverage ratio is also known as the EBITDA-to-interest coverage ratio, which is a financial ratio that is used to assess a company’s financial durability by determining whether it makes enough profit to pay off its interest expenses using pre-tax income.
An EBITDA coverage ratio over 10 is considered good. Over the last several years, the EBITDA coverage ratio has ranged between 11 and 14 for the S&P 500. You may also look at other businesses in different industries and their reported EBITDA coverage ratios to see how these companies measure up.
The formula for calculating EBITDA is straightforward:
Operating Profit + Depreciation + Amortization = EBITDA
This formula eliminates the non-operating effects unique to each business. By focusing on profitability before depreciation and amortization (which may vary significantly across industries) as the measure of business performance, EBITDA allows comparisons of companies across different industries and tax brackets.
Key Learning Points
- The EBITDA coverage ratio is the EBITDA-to-interest coverage ratio, which is a financial ratio used to assess whether a company makes enough profit to pay interest expenses using pre-tax income.
- To calculate the EBITDA coverage ratio, divide EBITDA by the total interest payment.
- EBITDA multiples vary for different industries and companies of various sizes. The size of the company, profitability, growth prospects, and the applicable industry will have an impact on its EBITDA multiple.
- Industries with higher risk and lower profit margins will have lower EBITDA multiples. Businesses with lower risk and higher, stable profits will have higher EBITDA multiples.
EBITDA to Interest Coverage Ratio
The EBITDA-to-interest coverage ratio is used to analyze a firm’s ability to cover its interest obligations. The formula divides earnings before interest, taxes, depreciation, and amortization by total interest payments, making it more inclusive than the standard interest coverage ratio.
EBITDA Multiples by Industry
As noted above, EBITDA multiples vary among industries and companies of various sizes. The size of a company, profitability, growth prospects, and the industry within which it operates will have an impact on its EBITDA. The table below illustrates the differences in average industry-specific multiples; multiples for individual companies within those industries will vary based on the size of the company.
EBITDA Coverage Ratio Calculation Example
There are two formulas used for the EBITDA-to-interest coverage ratio that differ slightly. Analysts may differ in opinion regarding which is more applicable depending on the company in question.
- EBITDA-to-interest coverage = (EBITDA + lease payments) / (loan interest payments + lease payments); and
- Interest coverage ratio, which is EBIT / interest expenses.
As an example, consider the following.
A company reports sales of $1,000,000. Salary expenses are $250,000, while utilities are $20,000. Lease payments are $100,000. The company also reports depreciation of $50,000 and interest expense of $120,000. To calculate the EBITDA-to-interest coverage ratio, first calculate the EBITDA by taking the company’s EBIT (earnings before interest and tax) and adding back depreciation and amortization. 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
Access the download to practice calculating the EBITDA coverage ratio and test your understanding.
Why are EBITDA Multiples Different in Different Businesses?
EBITDA multiples can vary widely within industries or sectors. There are several reasons for disparities:
First, EBITDA will typically be higher for a business with high expected growth. EBITDA is a measure of financial performance, and a company with prospects for good future performance due to valuable contracts or intellectual property is likely to be profitable in the future. This applies to businesses in high-growth sectors such as technology.
Second, a business with a higher profit margin will have a higher EBITDA multiple. Because current profitability (EBITDA margin) is higher, more cash is likely available for reserves and distribution to shareholders.
Third, a business with stable profits will have a higher EBITDA multiple because stability indicates that the business is less sensitive to the economic cycle. Stable profitability in the past is in most cases an indication of stable profits in the future, meaning that the risk for buyers or investors is lower. Higher earnings mean a higher EBITDA multiple.
Conversely, industries where risk is higher and profit margins lower will have lower EBITDA multiples. Examples include airlines, which operate on low and cyclical profit margins and are very sensitive to changes in fuel costs and the economic cycle, and oil and gas exploration and production, which are high risk and economically cyclical.
Conclusion
The EBITDA-to-interest coverage ratio is used to assess a company’s financial durability by examining whether it can cover interest expenses using 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 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 all-encompassing EBITDA.
The EBITDA coverage ratio measures the ability of an organization to pay off its loan (interest) and lease obligations. This measurement is used to review the solvency of entities that are highly leveraged. The ratio compares the EBITDA (earnings before interest, taxes, depreciation, and amortization) and lease payments of a business to the aggregate amount of its loan and lease payments.
The EBITDA coverage ratio yields more accurate results than the times interest earned measurement since the EBITDA portion of the ratio more closely approximates actual cash flows. This is because EBITDA strips noncash expenses away from earnings. Since interest and lease payments must be paid from cash flows, this ratio offers a fair representation of solvency.
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