When analysing the cash flow risk of a company, one of the ratio commonly used is the EBITDA/Interest Expense ratio. EBITDA is basically the Earnings Before Interest, Tax, Depreciation and Amortization of a company. The ratio is also known as the EBITDA-To-Interest Coverage Ratio. It can be used to measure a company’s ability to meet its interest expenses.
The formula for this ratio is:
EBITDA To Interest Coverage Ratio = EBITDA / Interest Payments
EBITDA Coverage Ratio is often compared with EBIT Coverage Ratio which formula is:
EBIT To Interest Coverage Ratio = EBIT / Interest Payments
However, EBITDA is typically seen as a better proxy for the operating cash flow of a company. When the ratio is equal to 1.0, it means that the company is generating only enough earnings to cover the interest payment of the company for 1 year. A low ratio indicates questionable cash flow issue in a company and it might not be of on-going concern while a high ratio is a sign of strong cash flows to cover its debt expenses.
For example, if a company has the following income statement:
Net income = $250,000
Interest expenses = $20,000
Income Tax = $10,000
Depreciation & Amortization = $50,000
The EBITDA Coverage Ratio = ($250,000 + $20,000 + $10,000 + $50,000) / $20,000 = 16.5
This means that the company has enough earnings to sustain 16.5 years of its interest expenses, if it stays stagnant.
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All views and opinions articulated in the article were expressed in Stanley Lim’s personal capacity and does not in any way represent those of his employer and other related entities. Stanley Lim does not own any companies mentioned above.
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