EBITDA Coverage Ratio

EBITDA coverage ratio is a solvency ratio that measures a company's ability to pay off its liabilities related to debts and leases using EBITDA. It is calculated by dividing the sum of EBITDA and lease payments by the sum of debt (interest and principal) payments and lease payments.

EBITDA coverage ratio analyzes sufficiency of a company's EBITDA to pay annual financial obligations. EBITDA is generally considered a proxy for cash flow.

EBITDA coverage ratio is a broader measure of solvency than the times interest earned ratio and fixed charge coverage ratio. While times interest earned ratio assesses ability of a company to pay off interest using earnings before interest and taxes (EBIT) and fixed charge coverage ratio studies its ability to pay only non-principal debt payments using earnings before interest, taxes and fixed charges, EBITDA coverage ratio compares both principal and interest components of financial obligations with a measure of operating cash flow.

Formula

EBITDA coverage ratio can be calculated using the following formula

EBITDA Coverage Ratio =EBITDA + Lease Payments
Interest Payments + Principal Repayments + Lease Payments

The formula includes the sum of EBITDA and lease payments in numerator. Similarly, interest, debt repayment and lease payments are in denominator because we want to know how many times these payments can be made out of EBITDA.

EBITDA equals EBIT plus depreciation and amortization and it approximates a company's cash flows more closely than its earnings do (because it excludes non-cash expenses of depreciation and amortization). Since debts are to be repaid using the cash flows generated, EBITDA coverage is a useful measure of a company's ability to pay off its debt repayment obligations. Lease payments are added back to EBITDA because EBITDA is calculated after subtracting lease payments and we want to assess a company's ability to pay debt payments using earnings before those payments are charged.

Example

Calculate EBITDA coverage ratio and times interest earned ratio for Company ABC using the following information:

Net income2,000,000
Income tax expense857,143
Interest expense1,000,000
Lease payments800,000
Principal repayment on debt2,000,000
Depreciation1,200,000
Amortization900,000

The relevant industry average for EBITDA coverage and TIE is 2 and 3 respectively.

Solution

EBITDA = 2,000,000 + 857,143 + 1,000,000 + 1,200,000 + 900,000 = 5,957,143

EBITDA Coverage Ratio =5,957,143 + 800,000= 1.78
1,000,000 + 2,000,000 + 800,000

EBIT = 2,000,000 + 857,143 + 1,000,000 = 3,857,143

Times Interest Earned =3,857,143= 3.86
1,000,000

EBITDA coverage ratio of 1.78 means that the company can safely pay off its periodic interest payment, debt principal repayment and lease payment obligations. However, the ratio is not as good as the industry average.

Times interest earned ratio of 3.86 tells that the company has the capacity to pay almost 4 times the current interest expense, and it is better than the industry average.

You can easily see that EBITDA coverage ratio has wider scope.

by Obaidullah Jan, ACA, CFA and last modified on

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