What is the EBITDA-to-Interest Coverage Ratio?
The EBITDA-to-interest coverage ratio (often shortened to EBITDA coverage) measures how well a company’s operating cash-generation (measured by EBITDA) covers its interest expenses. It is primarily a quick liquidity/creditability test used by lenders, credit analysts and private‑equity/leveraged‑buyout professionals to judge whether a business can service its debt.
Key definitions
– EBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization. It approximates operating cash flow before capital spending and taxes.
– Interest expense = total interest charged on debt during the measurement period (typically a year or trailing twelve months).
Why it matters
– A coverage ratio greater than 1.0 means EBITDA exceeds interest expense (the company “covers” interest).
– Higher ratios indicate greater ability to handle interest obligations and a lower perceived credit risk. Lenders and investors commonly prefer ratios well above 1.0 (many covenants specify minimums such as 2.0–3.0x).
– The ratio is a quick screen but not a substitute for in‑depth credit analysis because EBITDA ignores capital expenditures, principal repayments, taxes and working capital needs.
Formulas
Two frequently used variants:
1) EBITDA-to-Interest Coverage = EBITDA / Interest Expense
2) EBITDA‑plus‑leases Coverage = (EBITDA + Lease Payments) / Interest Expense
(Analysts add back lease payments when leases are treated more like financing than operating costs — check how leases are reported under ASC 842/IFRS 16 for comparability.)
How this differs from the traditional interest coverage ratio
– Traditional interest coverage ratio = EBIT / Interest Expense.
– Because EBITDA adds back depreciation and amortization, EBITDA coverage will usually be higher than EBIT‑based coverage. This can be useful for companies where depreciation/amortization is large, but it can also overstate available cash to service debt.
Step‑by‑step: how to calculate EBITDA-to-interest coverage
1. Choose the period (most common: last fiscal year or trailing twelve months).
2. Obtain the income statement (and notes) for that period.
3. Calculate EBIT:
– EBIT = Revenue − Operating expenses (exclude interest and taxes).
4. Calculate EBITDA:
– EBITDA = EBIT + Depreciation + Amortization. (If amortization is not shown separately, include any identifiable amortization of intangible assets.)
5. Decide whether to include lease payments:
– If leases are financing in nature for your analysis, add back cash lease payments to EBITDA (or use a consistent adjustment) — but be careful because new lease accounting standards changed comparability between firms.
6. Obtain total interest expense for the same period (from the income statement or notes).
7. Compute ratio:
– EBITDA-to-Interest Coverage = EBITDA (or adjusted EBITDA) ÷ Interest Expense.
8. Interpret:
– Compare to historical levels, industry peers and any debt covenant requirements. Flag trends (improving/declining).
Worked example (numbers from a hypothetical company)
Given:
– Revenue = $1,000,000
– Salary expense = $250,000
– Utilities = $20,000
– Lease payments = $100,000
– Depreciation = $50,000
– Interest expense = $120,000
Step A — compute EBIT:
– Operating expenses = 250,000 + 20,000 + 100,000 + 50,000 = 420,000
– EBIT = 1,000,000 − 420,000 = 580,000
Step B — compute EBITDA:
– EBITDA = EBIT + Depreciation = 580,000 + 50,000 = 630,000
Step C — EBITDA-to-interest coverage:
– EBITDA / Interest = 630,000 / 120,000 = 5.25x
Step D — variant adding lease payments (if analyst treats lease cash as financing):
– (EBITDA + Lease Payments) / Interest = (630,000 + 100,000) / 120,000 = 6.08x
Interpretation of the example
– A coverage of 5.25x (or 6.08x with lease add‑back) indicates the company generates materially more operating earnings than required to meet interest charges — typically a comfortable position. But this does not account for taxes, required capital expenditures, principal repayments or other cash uses.
Limitations and caveats
– EBITDA excludes capital expenditures and working capital needs, so it can overstate the cash available to pay interest, especially for capital‑intensive firms.
– EBITDA and interest coverage can be distorted by one‑time gains/losses, aggressive accounting or non‑recurring items; normalize EBITDA for a more accurate view.
– Lease accounting changes (ASC 842, IFRS 16) affect the comparability of EBITDA across companies and periods — some firms will show higher EBITDA when operating leases are recognized differently. Always check financial statement notes.
– Interest expense may fluctuate from period to period if debt levels or interest rates change; use TTM or forward‑looking EBITDA/interest for a better picture of current capacity.
– EBITDA coverage doesn’t capture principal repayment schedules — a firm might cover interest but still have near‑term principal maturities it cannot service.
Practical use cases and what to look for
– Credit assessment: Lenders use this to set covenants (e.g., minimum coverage ratios).
– M&A / LBO screening: Buyers use it to determine whether a target can support expected leverage.
– Trend and peer analysis: Compare a company’s coverage over time and to competitors to spot deterioration or improvement.
– Scenario testing: Model the effect of revenue declines, margin compression, rate increases or refinancing on coverage.
If the ratio is weak — practical steps management or analysts might consider
– Reduce debt or refinance to lower interest costs.
– Extend maturities to reduce near‑term interest/principal burden.
– Improve operating performance (cost reductions, price increases, margin improvement) to raise EBITDA.
– Defer discretionary capital expenditures or monetize non-core assets to improve cash flow.
– Renegotiate leases or convert operating leases to financing structures strategically (while minding accounting effects).
Checklist for robust analysis
– Use consistent definitions of EBITDA and interest across comparisons.
– Normalize EBITDA for non-recurring items.
– Check lease accounting and consider an adjusted measure for comparability.
– Review debt schedule for maturities, covenants and fixed vs variable rates.
– Compare to industry norms and covenant thresholds.
– Complement with other coverage and cash‑flow metrics (e.g., EBIT coverage, free cash flow to debt, interest coverage including taxes).
Sources and further reading
– Investopedia — “EBITDA-to-Interest Coverage Ratio” (source material): https://www.investopedia.com/terms/e/ebitdacoverinterestratio.asp
– Review a company’s audited financial statements and notes for the precise definitions of depreciation, amortization, lease treatment and interest expense used in the calculation.
If you’d like, I can:
– Calculate this ratio for a real company if you provide an income statement (or the company ticker), or
– Build a small Excel/TTS formula (with steps and cells labeled) you can paste into a spreadsheet to compute EBITDA-to-interest coverage automatically.