What it means
Interest cover ratios answer only half the question, because a loan has to be repaid as well as serviced. This ratio widens the test to cover the full set of fixed obligations, which is why lenders often treat it as the more honest measure of affordability.
EBITDA is used rather than EBIT because depreciation and amortisation are accounting charges rather than cash payments. Since the ratio is testing the ability to make actual payments, a cash-based profit measure is the more relevant starting point.
Leases appear on both the top and the bottom of the fraction for a technical reason. Lease costs are already deducted in arriving at EBITDA, so adding them back on top puts the ratio on a consistent footing with the lease payments counted as an obligation below.
Interpretation is stricter than for interest cover, because the denominator is larger. Lenders typically look for something above 1.2, since a ratio close to 1.0 leaves nothing at all for tax, capital spending or a bad quarter.
The nuance worth remembering is that EBITDA ignores the capital spending needed to keep assets working. A haulage or manufacturing business that must replace equipment every few years can pass this ratio while quietly running its fleet down, so it should be read next to maintenance capital expenditure.
Definitions vary between lenders, so the wording in the loan agreement matters more than the textbook version. Some exclude lease payments entirely, some include only the principal element of finance leases, and some add tax to the denominator, and each choice changes the answer.
In practice
Real-world examples
Example 1
A haulage firm reports EBITDA of $2,400,000 with lease payments of $600,000, interest of $300,000 and principal repayments of $900,000. Its ratio is $3,000,000 / $1,800,000 = 1.67 times, which its bank considers adequate for an asset-backed business.
Example 2
A care home operator is required by its lender to hold the ratio above 1.25 times but reports 1.10 times after a wage increase. The breach forces a renegotiation, and the lender agrees to a lower repayment schedule in exchange for a higher margin on the loan.
Example 3
A packaging company with EBITDA of $4,000,000, interest of $600,000 and no leases refinances to stretch annual principal repayments from $2,000,000 to $1,000,000. Coverage improves from $4,000,000 / $2,600,000 = 1.54 times to $4,000,000 / $1,600,000 = 2.50 times without any change in trading.
Think of it
EBITDA coverage shows if operating cash earnings can pay all your fixed financial obligations.
Formula
Calculation
EBITDA Coverage Ratio = (EBITDA + Lease Payments) / (Interest + Principal Repayments + Lease Payments)
A regional manufacturer reports EBITDA of $5,000,000 and pays $1,000,000 a year in lease costs, so the numerator is $5,000,000 + $1,000,000 = $6,000,000. Its obligations are interest of $800,000, scheduled principal repayments of $1,200,000 and the same $1,000,000 of lease payments, giving a denominator of $800,000 + $1,200,000 + $1,000,000 = $3,000,000. The ratio is $6,000,000 / $3,000,000 = 2.0 times. By comparison, the simpler debt service view of $5,000,000 / $2,000,000 gives 2.5 times, which shows how including leases tightens the test.Case study
Seen in the real world
Ferngrove Dairy is an entirely fictional processor used here as an illustrative example. It generated EBITDA of $6,000,000 and looked comfortably financed on interest cover alone, since interest was only $900,000 a year.
The picture changed when its lender applied the full coverage test. Adding lease payments of $1,200,000 to EBITDA gave a numerator of $7,200,000, while interest of $900,000, principal repayments of $2,100,000 and the $1,200,000 of leases gave a denominator of $4,200,000, so the ratio was $7,200,000 / $4,200,000 = 1.71 times.
That was still acceptable, but far less comfortable than the headline interest cover had suggested, and it changed the board's thinking. In this illustrative scenario the company paused a planned equipment lease for a year, protecting the ratio while it built up cash for the repayment schedule ahead.
Watch out
Common mistakes
- Leaving lease payments out of the denominator while still using an EBITDA figure that has them deducted, which flatters the ratio.
- Treating a ratio above 1.0 as safe, when there is nothing left over for tax, capital spending or an unexpected downturn.
- Using EBITDA as a proxy for cash without checking whether working capital has swallowed the profit before it reached the bank.
Questions
People also ask
How is this different from the EBITDA interest coverage ratio?
Interest coverage tests only the interest bill, while this ratio tests interest, capital repayments and lease commitments together.
Why add lease payments back at the top?
Because they have already been deducted in calculating EBITDA, and leaving them out would count the same cost twice once they appear in the denominator.
What ratio should a healthy business aim for?
Most lenders want to see at least 1.2 to 1.5 times, though asset-heavy businesses with very predictable contracted income are sometimes allowed to operate closer to the line.