Interest Coverage Ratios
Hi at all,
I've got a question regarding interest coverage ratios.
I've read the book "Equity Valuation and Analysis" and they state on page 110 regarding the EBITDA/EBIT ratio the following: "The key difference between the ratios is the exclusion of depreciation and amortization expense from the numerator of the second (EBIT) ratio. The rationale for excluding depreciation and amortization is that it represents a noncash charge, and therefore does not reduce the amount of available to meet its interest payments".
So my question is the why do I exclude them if they are non cash expenses, then EBITDA would be the right ratio because it states what we have left for paying interest (if all would be cash). Where is my thought mistake?
Thanks for your help!
There is no mistake.
There is a generally accepted interest debt coverage (EBIT over Interest Expense) and you see it tracked on a quarterly basis in every transaction. The lower the ratio, the more concerned you should be about the level of debt in a company. When EBIT over Interest Expense approaches 1.5, there is an immediate risk of financial distress.
However, EBIT is imperfect as a measure, for the reasons you specified. Therefore, there are additional ratios that sometimes get measured. Such as EBITDA over Interest Expense, or other adjusted EBIT metrics. The more debt ratios you measure, the better informed you are. If you choose other ratios as more appropriate, it will be hard to avoid using EBIT over Interest Expense. Why? Because it is 1) industry standard; and 2) super easy to set up and calculate automatically alongside any other ratios you may choose.
Good luck!
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