Ebitda ratio

The Ebitda coverage ratio, also known as the debt sustainability ratio, is mainly used to assess the company's ability to cover interest associated with the company's debts.

According to Paulson E. "The Ebit/Ebitda ratio compares the total investment in a company to its basic income before financial or accounting policy - related expenses have been subtracted.".

This indicator, however, has two minor shortcomings:

• Due to the fact that many companies rent their assets and thus have to make lease payments, interest on debt is not the only financial burden to which the company is exposed. It must reduce its debt on schedule, so if your installments or lease payments are not paid, your company may go bankrupt.
• The second disadvantage is the inability to represent all cash flows available for servicing the debt, especially if there are high depreciation charges. In order to take into account the above comments, the bankers presented the Ebitda coverage ratio as follows

$Ebitda\,coverage\,ratio={\frac {Ebitda+Lease\,payments}{Interest+Principal\,payments+Lease\,payments}}$

The perspective of a lender

From the perspective of a lender with obligation notes, debt is treated as a kind of investment in a company. The creditor's funds will be used to generate income from operations. The company is expected to get a higher rate of return on the use of this money than the interest rate paid to the lender by the company.

By debt, we can define assets, i.e. money that the company incurred for its use, instead of paying the seller or lender. Reducing the amount of cash on debt provides the outstanding amount of net debt, as this money can be used to pay off the debt immediately. The total capital currently invested in the company is not the book value of equity, but the market value of shares. If it is transformed into another form of assets, such as cash, it represents the total value of the shares. Investors generally allow other investment opportunities because they retain their origin in the company at market prices.

Understanding Ebitda

The term Ebitda is an indicator used for companies that are not already in the early stages of development but do not yet achieve sufficient income to support themselves. This ratio is a modified form of the P / E ratio for enterprises that have no profits. In the case of such enterprises, attention should also be paid to the ratio of price to sales and burning of cash. Ebitda is a measure used by companies with gross profit but not net profit. Every mention of Ebitda indicates that the company is not yet profitable, but sees positive Ebitda as a milestone in development. As a ratio, Ebitda lies between gross profit and net profit. He continues to deduct business expenses such as rates, energy, insurance, and office workers. It does not include financial interest related to interest, depreciation. Tax, depreciation, and Ebitda are often overrated, especially by directors who promote positive Ebitda to cover up the net loss: positive Ebitda is like a person who claims to live within his means if he excludes mortgage, loan repayment, and income tax.

Examples of Ebitda ratio

• The Ebitda coverage ratio can be used to measure the ability of a company to pay its debts with its operating income. This ratio is calculated by dividing a company's Ebitda (earnings before interest, taxes, depreciation, and amortization) by its total interest payments. If the ratio is greater than one, it indicates that the company is able to cover its total interest payments from its operating income.
• Another example of the Ebitda coverage ratio is to measure the ability of a company to cover its capital expenditure. This ratio is calculated by dividing a company's Ebitda by its total capital expenditure. If the ratio is greater than one, it indicates that the company is able to cover its capital expenditure from its operating income.
• A third example of the Ebitda coverage ratio is to measure the ability of a company to cover its debt service payments. This ratio is calculated by dividing a company's Ebitda by its total debt service payments. If the ratio is greater than one, it indicates that the company is able to cover its debt service payments from its operating income.

Advantages of Ebitda ratio

The Ebitda coverage ratio is a useful tool for assessing a company's ability to cover its debt obligations. Some of the advantages of using the Ebitda coverage ratio include:

• It provides an indication of the company's ability to service its current debt and to take on additional debt if needed.
• It is a measure of financial leverage, which can be used to compare companies of different sizes.
• It is a more reliable measure of debt coverage than other ratios, such as the Debt to Equity Ratio, because it takes into account operating expenses.
• It is a useful tool for evaluating a company's long-term financial health, as it shows the company's ability to meet its debt obligations over the long term.
• It can be used to evaluate the impact of changes in a company's operating performance on its debt coverage.

Limitations of Ebitda ratio

The Ebitda coverage ratio is a useful tool to evaluate a company's ability to meet debt obligations, however, it is not without its limitations. These limitations include:

• Ebitda does not take into account the costs of capital structures, such as taxes and interest payments, which can reduce the amount of cash available to service debt obligations.
• Ebitda does not factor in non-cash expenses such as depreciation and amortization, which can erode the value of a company's assets.
• The ratio does not consider the potential for future growth of a company, which could impact its ability to pay down debt.
• The ratio does not consider the risk associated with a company's debt, which could affect its ability to pay down debt.
• The ratio does not take into account the cost of capital, which can affect the cost of servicing debt.
• The ratio does not factor in any changes in the market or industry, which could impact a company's ability to pay its debt obligations.

Other approaches related to Ebitda ratio

The Ebitda coverage ratio is mainly used to assess the company's ability to cover interest associated with their debts. However, there are other approaches related to Ebitda ratio that can also be used to measure a company's financial health. These include:

• Debt to Ebitda Ratio: This ratio measures the total debt of a company relative to its Ebitda. A higher ratio indicates more debt relative to Ebitda and therefore higher risk for the company.
• Ebitda Margin Ratio: This ratio measures the company's Ebitda relative to its total revenue. A higher ratio indicates a more profitable company.
• Interest Coverage Ratio: This ratio measures the company's ability to pay interest payments on its debt. A higher ratio indicates a better ability to pay interest payments.

In summary, the Ebitda coverage ratio is a measure of a company's ability to cover interest payments on its debt. Other approaches related to this ratio can be used to assess a company's financial health and to measure their profitability and ability to pay interest payments.

Ebitda ratio — recommended articles

Capitalization ratio — Debt management ratio — Plowback Ratio — Fixed-Charge Coverage Ratio — Debt to total assets ratio — Capital gearing — Asset equity ratio — Solvency ratios — Degree of financial leverage

References

• Leach R. (2010), Ratios Made Simple: A beginner's guide to the key financial ratios Harriman House Limited
• OECD (2016),OECD/G20 Base Erosion and Profit Shifting Project Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action 4-2016 Update Inclusive Framework on BEPS: Inclusive Framework on BEPS OECD Publishing
• Paulson E. (2000), The Technology M&A Guidebook John Wiley & Sons
• Rosenbaum J. , Pearl J. (2013) Investment Banking Workbook John Wiley & Sons

Footnotes

Author: Barbara Rojek