EBITDA coverage ratio gauges the ability of a company to meet its debt obligations and leases (both capital and operating). In other words, it shows whether or not a company is able to pay interest and principal on its debt and to make lease payments. The value of 1 indicates that a company has sufficient funds to meet its debts and leases.
The formula of EBITDA coverage ratio is expressed as follows:
where EBITDA is earnings before interest, taxes, depreciation, and amortization.
The reason to add back lease payments in the numerator of the formula above is that they were already accounted in operating expenses.
Most companies disclose EBITDA and EBIT (also called operating income) figures in their financial statements, but you can also compute them using the formulae below:
EBIT = Net Sales – Cost of Sales – Operating Expenses
EBITDA = EBIT + Depreciation + Amortization
where EBIT is earnings before interest and taxes.
Please note that not all companies disclose EBIT, but if they do it can be found in the statement of income. The depreciation and amortization is disclosed in the cash flow statement, while lease payments and principal repayment are usually reported in the notes to financial statements.
The balance sheet of the XYZ Company is as follows:
Balance sheet, US$ in thousands
The reported statement of income for the current year is as follows:
The amount of depreciation and amortization expense disclosed in the cash flow statement is $2,680,000, and the total amount of lease payments reported in the current year is $1,575,000. Also in the current year the principal repayment came due in the amount of $2,500,000.
Thus, the EBITDA of the XYZ Company is $11,740,000.
EBITDA = $9,060,000 + $2,680,000 = $11,740,000
Let’s put all data available in the formula above.
Let’s assume that in the previous year the EBITDA coverage ratio was 1.925. Its current value of 2.166 compared with a baseline of 1.925 indicates that a company’s management has improved its ability to meet debts and leases.
EBITDA coverage ratio analysis
The EBITDA coverage ratio measures the ability of a company to meet its leases and debts (both principal and interest). So, a higher ratio number is favorable because it is an indicator of a company’s solvency in the long run. A lower number indicates that a company has difficulties in meeting its debt and lease obligations.
While EBITDA coverage ratio can be used to compare companies operating in different industries, it works best for companies of the same size working in the same industry. Thus, its value should also be compared with the industry average.
Let’s consider the example above and assume that the current industry average is 1.613.
The current value of 2.166 compared with the industry average of 1.613 indicates that the company generates sufficient funds to meet its debt and lease obligations.