What it means
Lenders want to know whether a borrower can comfortably afford its interest payments. The EBITDA cover interest ratio answers that by dividing a measure of operating profit by the interest expense for the same period.
A higher number means more breathing space, while a low number signals that interest is eating most of the profit. The reason EBITDA is used rather than net income is that it focuses on the cash-generating power of the business before the effects of tax and non-cash charges.
Depreciation and amortisation reduce reported profit but do not involve a cash payment in the period, so adding them back gives a fairer picture of the resources available to cover interest. Banks often write a minimum ratio into loan agreements as a covenant, which is a promise the borrower makes to keep certain financial measures above an agreed level.
If the ratio falls below the threshold, the lender may charge a higher rate, ask for more security or in serious cases demand early repayment. For this reason finance teams track the ratio closely and forecast it before taking on new debt.
There are some important limits. EBITDA ignores the cash spent on replacing equipment and the cash tied up in stock and receivables, so a business can show a healthy ratio and still be short of cash.
Some analysts therefore also look at a version that uses EBITDA minus capital spending. Comparisons need care across industries.
A software business with few physical assets may run a very high ratio, while a capital-intensive business such as a shipping company may operate comfortably at a lower one. What counts as healthy depends on how stable the earnings are and how the lender sets its tests.
It also helps to read the ratio together with the company's debt level. A ratio of 4.0 times is comfortable when debt is falling, but less reassuring if the business is planning to borrow much more, because interest will grow while earnings may not.
Many finance teams therefore run the ratio on forecast figures, including a downside case in which EBITDA drops by 20% or more.
In practice
Real-world examples.
Example
A bank is deciding whether to lend $5,000,000 to a furniture manufacturer. It calculates the ratio from the last three years of accounts and sets a covenant slightly below the lowest figure it saw.
Example
A start-up with a growing subscription business raises venture debt. The investor checks that forecast EBITDA covers the interest bill by a comfortable multiple before agreeing to the terms.
Example
A hotel group plans to refinance its loans at a higher interest rate. The finance director recalculates the ratio using the new interest cost to confirm the covenant will still be met.
Formula
Calculation
EBITDA cover interest ratio = EBITDA / Interest expense
Worked example for a manufacturing company:
EBITDA: $2,400,000
Interest expense: $600,000
Ratio = $2,400,000 / $600,000 = 4.0 times
The company earns enough EBITDA to pay its interest four times over. If the loan covenant required a minimum of 3.0 times, the business would pass with room to spare, and EBITDA could fall to $1,800,000 before the covenant was breached ($600,000 x 3.0).
The downside test is easy to run. If EBITDA fell by 20% from $2,400,000, it would be $2,400,000 x 0.80 = $1,920,000, and the ratio would be $1,920,000 / $600,000 = 3.2 times. That is still above a 3.0 times covenant, so the company would survive a 20% fall, but a 30% fall would not.Case study
Seen in the real world.
This is a fictional scenario. Brightwater Logistics, an invented freight company, reported EBITDA of $2,400,000 and interest costs of $600,000, giving a ratio of 4.0 times. Its lender had set a minimum covenant of 3.0 times.
When the company planned to borrow another $3,000,000 for new trucks, the finance director modelled the extra interest and found the ratio would drop to 3.2 times. That was still within the covenant, but with little room left, so the board decided to phase the purchase over two years instead of buying everything at once.
The board recorded the result in its risk register and agreed to review the ratio every quarter. It also set an internal early-warning level of 3.5 times, which was higher than the lender's covenant, so management would have time to react before the bank became concerned.
Watch out
Common mistakes.
- Using net profit instead of EBITDA in the numerator. That mixes in tax and non-cash charges, and the result is no longer the standard ratio.
- Reading a high ratio as proof of safety. EBITDA ignores capital spending and working capital, so cash can still be tight.
- Mixing periods, such as annual EBITDA with quarterly interest. Both figures must cover the same time span.
Questions
People also ask.
What is a good EBITDA cover interest ratio?
It depends on the industry and the lender, but many lenders look for at least 3 times, and higher for volatile businesses.
Is this the same as the interest cover ratio?
Not quite. The interest cover ratio normally uses EBIT, which is after depreciation and amortisation, so it is a stricter test.
What happens if the ratio falls below the covenant level?
The lender may charge a fee, raise the rate, ask for security or in serious cases require early repayment, so companies usually negotiate early.
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