EBITDA coverage ratio
/What is the EBITDA Coverage Ratio?
The EBITDA coverage ratio measures the ability of an organization to pay off its loan 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 loans and leases must be repaid from cash flows, the outcome of this ratio should give a fair representation of the solvency of a business.
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Formula for the EBITDA Coverage Ratio
The EBITDA coverage ratio formula is calculated as the earnings before interest, taxes, depreciation and amortization of the reporting entity, plus its lease payment obligations, and divided by the sum of its loan payment and lease payment obligations. The formula is as follows:
(EBITDA + Lease payments) ÷ (Loan payments + Lease payments) = EBITDA coverage ratio
The lease payments figure used in this formula include only minimum lease payments. The payments associated with any lease term extensions are not included.
Example of the EBITDA Coverage Ratio
As an example of the EBITDA coverage ratio, the annual EBITDA of ABC International is $550,000. It makes annual loan payments of $250,000 and lease payments of $50,000. Its EBITDA coverage ratio is:
($550,000 EBITDA + $50,000 Lease payments) ÷ ($250,000 Debt payments + $50,000 Lease payments)
= 2:1 ratio
The 2:1 ratio might indicate a reasonable ability to repay debts. However, it does not account for any investment requirements for a business, such as the need to increase working capital or buy additional fixed assets.
Advantages of the EBITDA Coverage Ratio
There are several advantages associated with using the EBITDA coverage ratio, which are as follows:
Good focus on operational performance. Because the ratio excludes non-operational and non-cash expenses, it provides a clear picture of the company's operational performance. This helps to assess a company's ability to service its debt from ongoing business operations without the influence of accounting practices or capital structure.
Comparability. By excluding interest, taxes, and non-cash items, the ratio makes it easier to compare companies across industries or regions with different tax regimes and capital structures.
Approximates cash flow. EBITDA approximates cash flow generated from operations, which provides insights into whether a company generates enough cash flow to cover its fixed financial commitments.
Highlights leverage and solvency. The ratio provides a snapshot of a company's leverage and its ability to service debt, which is valuable for creditors, lenders, and investors in assessing financial risk.
Useful for debt restructurings. For companies in financial distress or considering restructuring, this ratio is a critical metric in determining their ability to handle restructured payment terms.