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Understanding the EBITDA Coverage Ratio as a Small Business Owner
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If you want to measure multiple aspects of your business, calculating your EBITDA would open a window into your company’s financial health.
EBITDA is an acronym that stands for earnings before interest, taxes, depreciation and amortization. Your EBITDA measures your business’ profitability based on information from your income statement.
To find your EBITDA, use the following formula:
EBITDA = Net income + Interest expense + Taxes + Depreciation + Amortization Expense
You can use EBITDA to calculate several indicators of your business’s overall health and performance, such as your operating margins and how well you control your expenses, said Susan Chaplinsky, business administration professor at the University of Virginia’s Darden School of Business. Small businesses may also use EBITDA to determine valuation. EBITDA could help you figure out how much your business is worth beyond your revenue, which you would need to know if you’re considering selling the company.
EBITDA may also appear in a business loan agreement, as banks and lenders often require borrowers to maintain a minimum EBITDA as an indicator of their ability to make payments.
“Anybody who is looking at the company looks at the EBITDA,” Chaplinsky said.
What is EBITDA coverage ratio?
EBITDA coverage ratio is a credit metric that shows whether your business makes enough profit to cover your debts, Chaplinsky said.
“The higher the coverage is, the more it means you have coverage of what’s required of your loan payments,” she added.
To find your EBITDA coverage ratio, you would divide EBITDA by interest expense. Your interest expense includes any mandatory debt payments. Here’s an example: If you have $50 million in EBITDA and $8 million in interest expense, your EBITDA coverage ratio would be about 6.
You could also determine your EBITDA coverage ratio by dividing your debt by your EBITDA, said Jack Craven, president and founder of John F. Craven, CPA, LLC in New York. For example, if your debt is $10 million and your EBITDA is $2 million, your EBITDA coverage ratio would be 5.
When you obtain business financing, your loan agreement would spell out how the lender would like you to calculate your EBITDA coverage ratio, Craven said. You must follow the EBITDA formula that the lender specifies to remain compliant with your loan agreement. Check with your accountant or financial adviser to ensure you make the right calculations.
“There is no generally accepted methodology,” he said. “Every lender may have its own EBITDA formula.”
The importance of EBITDA coverage ratio
Your EBITDA coverage ratio informs lenders of your ability to pay them back if they loan you money. The better your ratio, the better position you would be in to get approved for financing. Banks typically won’t lend to a business with an EBITDA coverage ratio below 2, Chaplinsky said. However, a good coverage ratio may vary from one industry to the next.
“The more profits you have, the more cash your operation is throwing off in order to be able to pay your financial lenders,” she said.
However, you may want to maintain a lower coverage ratio, depending on which formula you use, Craven said. If you’re dividing debt by EBITDA, a lower coverage ratio would indicate less debt.
Banks may use EBITDA as a whole to measure your business’s performance over time, Chaplinsky said. Your EBITDA could be used to find your operating margin, which is equal to your earnings before interest and taxes, or EBIT. Your operating margin shows how efficiently you’re running your company. If your operating margin is high, that means you have more money left over after you pay expenses, Chaplinsky said. Banks would look at how well you manage your expenses compared with other businesses they’ve loaned to, she said.
“If you’re assessing the inherent profitability of a company, you would look at operating income as a very key metric,” she said.
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Interpreting your EBITDA coverage ratio
Your EBITDA coverage ratio indicates how much profit your business is generating in relation to how much debt you carry. You should be making enough money to remain profitable while maintaining on-time payments to your lender.
Lenders monitor your coverage ratio to make sure you stay on track to pay back your loan. When you take out a loan, you should fully understand what EBITDA coverage ratio your lender requires you to uphold while paying off your debt, Chaplinsky said.
“They’re going to look at how your performance is tracking over time in terms of your expense control,” she said.
EBITDA coverage ratios vary from industry to industry, said Grant Bledsoe, CPA and founder of Three Oaks Capital Management. A law firm and a manufacturing company, for example, would have different EBITDA coverage ratios because law firms rarely carry debt while manufacturers need equipment and other assets, leading to more debt. For that reason, EBITDA coverage ratio is more useful in certain industries, Bledsoe added.
“When you have greater debt and interest obligations, lenders need more confidence you’ll be able to make payments,” Bledsoe said.
Whether your EBITDA as a whole is good or bad also depends on your peers within your industry, Chaplinsky said. All companies have expenses that affect EBITDA. You should look at the EBITDA of the top companies in your industry that have high investor interest, Chaplinsky said. Comparing your operating margins would also give you an idea of how you stack up.
How to improve your EBITDA coverage ratio
Your EBITDA coverage ratio improves as your debt and loan balances come down, Chaplinsky said. The fewer business expenses you have, the further you can stretch your profits, improving your coverage ratio.
Refinancing your business loans to get a lower interest rate would help you pay off your balance faster and improve your EBITDA coverage ratio, Chaplinsky said. Increasing your profitability would also improve your ratio, as you would have more money to cover your debts.
Anything you can do to increase cash flow would help, Bledsoe said. Boosting revenue, decreasing overhead costs or increasing your staff’s efficiency would have a positive effect on your EBITDA coverage ratio.
You could also alter your payment schedule to pay down your debt over a longer period of time, decreasing monthly payments. This would expand your cash flow and ultimately improve your coverage ratio, Bledsoe said.
The bottom line
Your EBITDA coverage ratio would be of the most interest to lenders and prospective buyers or investors, Bledsoe said. The ratio indicates how much free cash flow your company has to distribute to stakeholders or pay off debts.
“Lenders need to measure a company’s capacity and willingness to repay debt before lending money,” Bledsoe said. “EBITDA coverage is one of the most direct ways to measure a company’s capacity to repay loans.”
How you calculate that ratio could depend on who you’re working with, Craven said. A lender would typically decide how they’d like you to determine your EBITDA coverage ratio. Make sure you follow the correct EBITDA formula to avoid violating your loan agreement.