The world of small business accounting is filled with acronyms: FICO score. DSCR. LTV ratio. EBITDA coverage ratio.
But don’t stress out—we’re here to talk about that last one.
When you’re applying for a business loan, you’ll probably run across the words “EBITDA coverage ratio” more than once. This ratio is a key indicator of the financial health of your business, and having a low one strongly correlates with default.
But what exactly is an EBITDA coverage ratio, and how can you calculate your own?
EBITDA stands for Earnings Before Interest, Tax, Depreciation, and Amortization. It’s another way to measure your business’s income, along with net income and operating income, as well as cash flow and revenue. Differentiating between these three can be tricky, so let’s start off with some definitions. (By the way, you can find all of these on your income statement.)
Earnings: You’ve probably got this one! It refers to the amount of profit you make in a specific period of time—usually a quarter or a full year. “Profit” and “income” also usually mean the same thing.
Interest: This is any interest payment you make on existing loans or lines of credit. In some cases, you might receive interest payments from investments, so “interest” could refer to the net figure: interest income – interest expense.
Tax: What you’re required to pay in income taxes.
Depreciation: Depreciation is relevant for “tangible assets,” which have a physical form—like your office building or any equipment you use. Over time, any tangible assets will depreciate in quality, meaning that they lose value. (A car that’s ten years old is usually worth less than a car that’s only two years old, for example.) Depreciation takes into account the diminishing value of your tangible assets, so every accounting year a little bit of the cost of that car would be added into your accounting statements.
Amortization: Amortization, on the other hand, is for “intangible assets” like patents or copyrights. Aside from that, it’s pretty much the same as depreciation: a little bit of the cost of the asset will be added to your accounting statements for as long as that asset continues to be useable.
Putting all of these together, EBITDA is a way to measure your earnings without taking the costs of interest, tax, depreciation, or amortization into account.
You also might hear of the acronym EBIT, or Earnings Before Interest and Tax. You probably guessed correctly that this figure ignores interest and tax, but does include depreciation and amortization.
Revenue refers to all of the money your company pulls in through sales. It’s also known as gross income. It’ll be at the top of your income statement and all the other figures will be calculated from your revenue.
Operating income is the same as EBIT. It factors in costs like the cost of goods sold (COGS), rent, utilities, and depreciation, subtracting these costs from your revenue.
Net income will be at the bottom of your income statement. In addition to all the above costs, it factors in interest, tax, and payments on one-time events (like lawsuits).
Your cash flow is an analysis of the amount of money that’s coming into your business versus the amount of money going out. It might sound like this is the same as profitability, but it’s actually not: because of timing problems with sales and accounts receivable, you can be profitable without being cash flow positive. (And likewise, you can be cash flow positive without showing a profit on your tax returns—if you’re trying to save on business taxes.)
To calculate EBITDA, start by calculating EBIT. You can do this in one of two ways:
Once you have your EBIT, add back in depreciation and amortization:
Net income + interest + taxes + depreciation + amortization
Revenue – operating expenses + depreciation + amortization
Basically, EBITDA is a measure of your business’s profit that takes some things into account (like revenue and operating expenses) and not other things (tax, interest, depreciation and amortization). It will give lenders a slightly different picture of your business’s finances than your operating income, your net income, or your cash flow.
Now that you’re an expert, let’s talk about the coverage ratio.
The coverage ratio compares your EBITDA to your company’s liabilities—your debt and your lease payments. The goal is to see whether or not you’re likely to afford to make your payments, given your profitability.
If the ratio is 1, then you’ll be able to pay off your debts, but just barely. The average is a ratio of around 2, according to Accounting Explained, but higher is better: a higher ratio means that you have more money and less debt.
The formula for your EBITDA coverage ratio is:
(EBITDA + Lease payments) / (Interest payments + Principal repayments + lease payments)
So let’s take an example, because all of this jargon can get a little confusing.
Let’s pretend that you run a small homemade pie shop called Slices of Heaven. You’re looking over your financial statements for the year—and you have your income statement and your balance sheet in front of you, thanks to your stellar accountant.
How are you going to calculate your EBITDA coverage ratio?
Here’s what you’ve got so far:
Net income: $100,000
Interest expense: $10,000
Operating profit: $65,000
Lease payments: $50,000
Principal repayment: $30,000
First off, your EBIT is the same as your operating profit, but you can also calculate it by subtracting interest and tax from net income:
$100,000 / ($10,000 + $25,000) = $65,000
To get EBITDA, you need to add back in depreciation and amortization:
$65,000 + $10,000 + $5,000 = $80,000
Finally, for the EBITDA coverage ratio, remember that
Plugging the numbers in, that becomes:
($80,000 + $50,000) / ($10,000 + $30,000 + $50,000) = $130,000 / $90,000 = 1.44
With an EBITDA coverage ratio of 1.44, you’ll be able to pay off your debts, but you don’t have too significant of a cushion to fall back on.
If your net income were $150,000 instead of $100,000 (let’s keep the taxes the same just for the sake of simplicity, even though in real life they would then be higher), your EBITDA coverage ratio would be much better:
EBIT = $150,000 / ($10,000 + $25,000) = $115,000
EBITDA = $115,000 + $10,000 + $5,000 = $130,000
EBITDA coverage ratio = ($130,000 + $50,000) / ($10,000 + $30,000 + $50,000) = $180,000 / $90,000 = 2
Now that you’ve gone through the trouble of understanding EBITDA and calculating your own EBITDA coverage ratio, you’re probably wondering…
Why did I just do that?
Just like with the FCCR, the EBITDA coverage ratio is a figure that lenders, especially banks, might look at when evaluating whether or not your business is a safe bet.
Having an equation that works for all companies lets lenders compare your business to others in the industry. It also gives them the chance to see how your business has done over time: if your EBITDA coverage ratio is a little low, but it was even lower last year, that’s a good sign, because it means that you’re managing to pay off your debt effectively.
Meanwhile, if it’s decreasing year-to-year, your EBITDA coverage ratio will suggest that you’re not handling your debt well and the lender might hesitate before offering you a loan.
If you’re keeping your business records and financial statements up to date, you can calculate your EBITDA coverage ratio on your own. Being aware of this metric will help you better understand what kinds of debt you can handle—and whether or not you’ll be successful in taking on more.