The last of the leverage ratios isn’t really a pure leverage indicator but augments the debt ratio. Debt requires the payment of interest and so an indicator of the ability to pay this interest is needed. This is the interest coverage ratio. It basically identifies how many times earnings can pay the interest required by existing debt. The formula consists of a denominator which is the interest paid in the current year and a numerator of earnings before interest, taxes, depreciation and amortization (EBITDA). The formula is:
Interest Coverage Ratio = Earnings Before Interest, Taxes, Deprec. & Amort.
For a user of this ratio, the most difficult element is understanding the EBITDA value. This article starts out by examining the earnings aspect and its effect on the ratio. Once EBITDA is understood, it then becomes elementary to understand the fundamentals of the interest coverage ratio and how it is applied in small business. Finally, some insights to this ratio and the debt ratio are described to tie leverage ratios together.
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
To understand earnings before interest, taxes, depreciation and amortization the reader must first be aware of an income statement’s (profit and loss statement’s) structure. Here is the basic format:
NAME OF COMPANY
Income Statement (Summary Format)
Period Ending ZZ/ZZ/ZZZ (Usually One Year)
Cost of Sales Z,ZZZ,ZZZ
Gross Profit ZZZ,ZZZ
Expenses (Non-Capital Related) ZZZ,ZZZ
Operational Profit ZZZ,ZZZ
Capital Costs ZZZ,ZZZ
Taxes ZZ ZZZ
Net Profit $ZZ ZZZ
EBITDA represents profit before certain costs of capital. Costs of capital include the following:
A) Depreciation – Allocation of fixed asset (tangible) acquisition costs based on predetermined schedules
B) Amortization – Allocation of intangible costs (copyrights, trademarks, patents and legal agreements – goodwill, financial arrangements etc.) over the expected utilization of the asset
C) Interest on Debt – long-term debt interest (does not include principal portion of debt service)
D) Replacement Reserves – used in the real estate rental industry
In effect, EBITDA is very similar to operational profit as taxes are also excluded from operational profit. Based on this, average readers would then think that EBITDA and operational profit are one and the same. However, this is not true. Many smaller businesses do not separate capital costs from expenses and include them in expenses like below:
Gross Profit $ZZZ,ZZZ
– Management $ZZZ,ZZZ
– Facilities ZZ,ZZZ
– Insurance ZZ,ZZZ
– Office Operations ZZ,ZZZ
– Taxes & Licenses ZZ,ZZZ
– Marketing/Advertising ZZ,ZZZ
– Other Z,ZZZ
– Capital Costs ZZ,ZZZ
Sub-Total Expenses ZZZ,ZZZ
Operational (sometimes just) Profit ZZZ,ZZZ
Net Profit $ZZ ZZZ
Others will include depreciation and amortization in expenses and then interest after operational profit. The secret to determine EBITDA is identifying the four distinct costs of interest, depreciation, amortization and income taxes. Simply add these costs back to net profit to calculate EBITDA.
Two important insights to EBITDA are necessary to help you understand this term well.
First, taxes in the acronym refers to traditional income taxes. A business pays a multitude of taxes including:
* Revenue Taxes – a local government fee on sales and not net profit
* Business Licenses – a legal compliance fee
* State Corporation Renewal – corporate name annual renewal fee
* Professional Licenses Renewal
* Excise, Tariffs, and Transportation Tags
* Consumption, Consumer, Recycling, and other state fees
* Real Estate Taxes
* Property Taxes
* Franchise Fee – an annual Secretary of State or Department of Revenue
Sales taxes are a pass-through trust relationship with the state or local government and therefore not included in the income statement. Only income taxes are included as a part of the EBITDA formula. Therefore, the expense group of taxes and licenses refers to the items above which are a function of EBITDA, i.e. they must be deducted to determine EBITDA. The ‘T’ in the acronym refers to income taxes only.
Secondly, some analysts believe EBITDA is also the cash profit before interest and taxes. This is because depreciation and amortization are non-cash expenses. Thus, the false assumption that EBITDA equals cash profit to service debt and payables. Cash profit also includes changes in current assets and liabilities. Therefore EBITDA does not equal cash flow from operations.
For more detailed information and explanations related to EBITDA, please refer to the following:
Fundamentals of the Interest Coverage Ratio
The primary goal of leverage is using debt to ramp up sales that in turn generate operational profit that can satisfy the debt service requirement and still generate additional net profit. The problem with debt is the responsibility to pay interest. How many times interest is covered determines the viability of debt. In small business it is the banking industry that utilizes this ratio. They often insert terms in their legal documents (loan terms/note clauses) mandating a minimum coverage ratio for debt.
As an example, interest coverage ratios for real estate intensive operations are 1.3 to 1 or greater. Here is an example.
Stem River Apartments must refinance its mortgage note coming due in one year. Negotiations with various banks indicate a minimum interest coverage ratio of 1.38:1 to as high as 1.72:1. The institution requiring a 1.72:1 ratio has the lowest interest rate for its note. The following is Stem River’s interest coverage ratio based on the last three years financial performance.
2014 2015 2016
Net Rents $2,281,476 $2,307,592 $2,316,409
Expenses B/F Capital Costs 1,619,814 1,616,853 1,582,311
Operational Profit $661,662 $690,739 $734,098
– Interest 279,841 271,306 256,811
– Depreciation 316,202 313,863 309,757
– Replacement Reserves 82,616 91,802 79,693
– Amortization 23,716 23,716 23,716
Profit ($40,713) ($9,948) $64,121
Interest Coverage Ratio:
EBITDA $661,662 $690,739 $734,098
Interest Expense $279,841 $271,306 $256,811
Ratio 2.36 2.54 2.86
Stem River Apartments will easily qualify for the lower interest rate note offered by one of the financial institutions.
In the above example, operational profit just so happens to equal EBITDA. Notice taxes are not included in the financial performance report. This is because most real estate based operations are set up as pass-through entities (partnerships, limited liability corporations and in some cases S-Corporations). Thus, taxes are the responsibility of the individual owners and not the entity. As stated in the prior section, users of this formula often have to rearrange financial data to determine EBITDA.
Now for some side notes related to real estate based entities. Typically, replacement reserves are set asides for regular upgrades to the units or for exterior improvements/modernization with office/retail and condominiums. These monies are paid with the mortgage payment and held in trust and paid out when actual improvements are made. In reality, replacement reserve values should be deducted from operational profit to calculate EBITDA. Therefore the interest coverage ratio is modified to equal adjusted EBITDA as follows:
2014 2015 2016
Operational Profit $661,662 $690,739 $734,098
Less: Replacement Reserves 82,616 91,802 79,693
EBITDA (Adjusted) $579,046 $598,837 $654,405
Interest 279,841 271,306 256,811
Interest Coverage Ratio 2.07:1 2.21:1 2.54:1
Another interesting item is amortization in real estate. Often amortization is a function of the financing of the mortgage note from years earlier, i.e. the closing costs. These closing costs were either paid from the note proceeds or actual cash out in the year the note was created. In that respective year, that cash payment was not an actual expense to calculate operating profit; yet the interest coverage ratio is designed to assess the ability to generate cash flow to service the interest component of debt service. Therefore, a prudent financial investor would deduct this amortization value as if it were indeed a function of operational profit as equal to EBITDA, i.e. a traditional expense of interest. In the above example, the interest coverage ratio would still exceed 1.72:1 if financing amortization were deducted to determine traditional EBITDA.
The key to this formula is of course the spread between EBITDA and the interest. The greater the spread the higher the ratio. Using the above illustration, imagine EBITDA at $900,000 with no change in interest for 2016, the interest coverage ratio increases to 3.5:1. Also notice that the total interest decreases from year to year.
Why? Well, with each mortgage payment principal is paid thus the amount of interest decreases the following year due to a smaller principal balance. Even something as simple as the interest rate on the note makes a significant impact on the rate. Here is an illustration.
Using Stem River’s information from above, suppose the interest rate on the current note is 5.21%. The new note will have an interest rate of 4.85% and the note’s principal is $4,915,000. This means that in 2017, the total interest paid will approximate $235,000. Assuming an EBITDA of $654,000 (matching 2016’s amount) the forward looking interest coverage ratio will be 2.78:1, well above the current 2.54:1. This is a 9.5% improvement over 2016. A small change in the interest rate generates a significant increase in the ratio and saves Stem River Apartments about $21,000 per year in interest.
This is why it is critical to understand this ratio’s meaning. The higher the ratio, the more comfort in the ability to service the debt. Basically, as the ratio increases, the debt leverage is decreasing. The following is a table indicating interest coverage ratio zones and their respective meanings.
5:1 Excellent ratio, leverage is not being exercised or is utilized appropriately. Business is generating income to service debt principal and payouts to owners.
> 3:1 < 5:1 Good range, easily manageable; must watch cash flow to ensure all parties (lenders and owners) are paid.
> 1.5:1 < 3:1 Requires scrutiny and cash flow will have issues; there may be a requirement to swap debt in order to continuously service debt; very unlikely dividends can be paid.
< 1.5:1 Trouble, earnings become essential to meet cash flow requirements. A very uncomfortable zone to operate with as an owner.
The interest coverage ratio is also used to evaluate the use of debt leverage. If the ratio increases with additional debt, it means the marginal gross profit generated from the additional sales is covering the additional interest costs as the interest coverage ratio improves. For illustration purposes, suppose the current interest coverage ratio is 3.5:1 on EBITDA of $700,000 with interest of $200,000. The company borrows $2,000,000 with additional interest of $100,000 the following year. EBITDA increases to $900,000. What happens to the interest coverage ratio?
Existing Following Year
EBITDA $700,000 $900,000
Interest $200,000 $300,000
Interest Coverage Ratio 3.5:1 3:1
Take note that interest coverage ratio decreases to 3:1 due to the additional interest service. The marginal increase in EBITDA is $200,000. Of this, an additional $100,000 is used to service interest leaving $100,000 to cover principal payments. Assuming a typical amortization of the principal amount, it will take at least 13 years to pay back the principal balance of the loan. Assuming this will happen over one full economic cycle*, it means a recession will more than likely create solvency issues at best and bankruptcy as the most likely outcome. The decrease in revenue, corresponding profit and finally the EBITDA’s result will most likely not be enough to service the debt. Ideally management will want a minimum of a 50% increase in the interest coverage ratio to satisfy the cash flow to service debt (interest and principal payments) and pay off the debt in less than one full economic cycle*.
Assuming the same existing EBITDA and interest as above but now the additional $2,000,000 generates an additional $500,000 per year in EBITDA; what is the new interest coverage ratio?
Existing Following Year
EBITDA $700,000 $1,200,000
Interest $200,000 $300,000
Interest Coverage Ratio 3.5:1 4:1
More importantly, the additional $500,000 less interest of $100,000 allows the business to pay back the debt principal in less than five years, well within one economic cycle*.
* Economic cycles vary between 11 and 17 years on average.
Small Business Application
For small business the real value of this ratio is its ability to define cash flow status. The higher the ratio, i.e. getting it up to greater than 5:1 the more likely cash flow is not an issue for the company. Remember, this ratio does not identify if the operation has the cash flow to service debt. It merely states the ability of the earnings to service the interest component.
The earnings are an accrual based result and not a cash based value. It is possible to have great earnings and negative cash flow from operations. If cash flow from operations is less than earnings before interest, taxes, depreciation and amortization, debt becomes more critical in the eyes of management. This is why higher interest coverage ratios are required in small business. Argumentatively servicing debt is the biggest macro issue for a small business. Ratios of less than 5:1 can wreak havoc on the overall finances for the business.
Rule of Thumb: If your revenues are less than $20 Million/Year use a 5:1 ratio as your minimum standard of an acceptable interest coverage ratio.
Insights to the Interest Coverage Ratio
The relationship of the debt ratio and interest coverage ratio is like a scale with the debt ratio on one side and the interest coverage ratio on the other. As debt increases, interest payments increase lowering the interest coverage ratio. The idea is to purchase assets with debt that will increase earnings so the scale doesn’t tip. Remember earnings growth is necessary from the use of additional debt to service that interest payment. In reality, the ideal result is that any increase in debt will actually cause an increase in the interest coverage ratio. This means earnings are going way up and in turn interest is covered and profits can service the principal requirements. This is the desirable effect of leverage. Ultimately this type of performance will add profit to the bottom line and value to the business.
Another issue related to interest coverage ratios pertains to off balance sheet financing including leases and rental agreements. Currently Generally Accepted Accounting Principles (GAAP) does not require recognition of leases as traditional liabilities with an interest component. There is expectation of a change in 2017 or 2018 related to this issue which will greatly affect interest coverage ratios and other debt ratios. Readers of financial reports should be aware of the impact leases have on the interest coverage ratio as long-term leases reduce the overall interest coverage ratio.
A third and final insight concerns the historical pattern of this ratio. Most ratios should be viewed or interpreted based on their pattern. That guideline is not really applicable to the interest coverage ratio. This is because the ratio is principled in the EBITDA value which usually fluctuates significantly from year to year. Furthermore typical interest payments will decrease from year to year as debt principal is paid down. In reality, the ratio should improve from one accounting period to the next if all other factors remain stable. Thus, the results will vary almost wildly from one year to the next. Use the ratio as an indicator of trouble like an idiot light on the car’s dashboard: “Warning, either debt is too high or there are earning issues.”
Summary – Interest Coverage Ratio
The interest coverage ratio is used in conjunction with the debt ratio to evaluate the ability of earnings to service the interest component of debt payments. It is calculated by dividing earnings before interest, taxes, depreciation and amortization by the total interest paid. The higher the ratio the more likely management can pay interest and the corresponding debt principal payments (debt service). Users of this ratio must first accept the fact that EBITDA does not equate to profit or cash flow from operations; it most closely represents the accrual based operational profit. Ideal ratios exceed 3:1 and should exceed 5:1 in small business operations. The greater the spread between EBITDA and interest paid, the higher the interest coverage ratio. Use this ratio with the debt ratio. As the debt ratio increases the interest coverage ratio should increase as leverage is suppose to increase earnings at a greater rate than the growth of the corresponding interest for that additional debt. The two ratios have a strong connection and should be evaluated together. Act on Knowledge.