Question

Which interest coverage ratio, EBITDA to interest or EBITA to interest, will lead to a higher number? When is the EBITDA interest ratio more appropriate than EBITA ratio? When is the EBITA interest coverage ratio more appropriate than the EBITDA ratio?

Answer 1

The interest coverage ratio is used to determine how easily a company can pay its interest expenses on outstanding debt. The ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the company's interest expenses for the same period.

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 profitable enough to pay off its interest expenses.
The ratio is calculated as follows:

EBITDA to Interest Coverage Ratio = EBITDA / Interest Payments

The EBITDA-to-interest coverage ratio is also known as EBITDA coverage.

BREAKING DOWN 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)

and

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 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

= 3.65