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.
EBITDA is essentially net income with interest, taxes, depreciation, and amortization added back to it and can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.
The ratio compares the EBITDA (earnings before interest, taxes, depreciation, and amortization) and leases payments of a business to the aggregate amount of its debt and lease payments. The formula is:
(EBITDA + Lease payments) / (Loan payments + Lease payments)
For example, the annual EBITDA of ABC International is $550,000. It makes annual debt payments of $250,000 and leases 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.
The EBITDA coverage ratio yields more accurate results than the time’s 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.
