Debt Coverage

In the posting Why Debt Ratios Matter we looked briefly at what debt really is, one way of measuring it, and how the mix of debt and equity played a role in how appropriately a business was financed. Now let’s look at servicing debt, also known as debt coverage.

What Determines Debt Coverage?

Think about this from a personal perspective. Imagine you took out a loan to buy some furniture for your home, and it was one of those loans where you only paid interest for the first year. Starting in the second year you would be required to start paying the principle as well. If you are unable to pay the interest as due, you may find your furniture repossessed. The same scenario applies if you are unable to pay the principle as due. Now let’s turn to a business and look at the same things from that perspective using two key financial ratios.

Interest Coverage Ratio

The interest coverage ratio is calculated as follows:

Interest coverage ratio = EBITDA / Interest Expense

EBITDA is defined as Annual Earnings Before Interest, Taxes, Depreciation, and Amortization. It is used to examine profitability excluding the impact of accounting decisions (like equipment purchases) and financial decisions (obtaining loans, etc.).

What this ratio indicates is the ability of a company to service the interest on debt and is considered an indication of a company’s credit quality or worthiness. A low ratio indicates that the company may have trouble meeting interest payments, while a high ratio tends to indicate that servicing interest payments should not be a problem.

I use the words “indicate” and “should” in the above paragraph as this calculation really misses a key component of a company’s liquidity – cash flow. Yes, the EBITDA may be large in regards to the interest payments, but unless profits are converted to sufficient cash then interest cannot be paid. This is just another reason to stay on top of accounts receivable outstanding (See 3 Low Cost Sources of Cash – Part 2 and inventory turnover (See 3 Low Cost Sources of Cash – Part 1).

If you are not familiar with the interest coverage ratio you should be. As long as you take into consideration your cash flow, it can tell you a lot.

Debt Leverage Ratio

The debt leverage ratio is another important indicator of a company’s ability to service debt obligations. It is calculated as:

Debt leverage ratio = Total Liabilities / EDITDA

See the previous section for the definition of EDITDA. What this ratio shows is how well a company can cover debt repayment out of the company’s annual profits. Some say out of the annual cash flow, but that assumes that all EDITDA is converted to cash, which is seldom the case. Again, the need to convert profits to cash plays into the importance of managing all your assets, but particularly accounts receivable collections and inventory turnover. The lower this ratio the better the indication that the debt can be serviced out of profits.

As with the interest coverage ratio, you should be familiar with the debt leverage ratio and use it, but when doing so consider your cash flow. Your company can be highly profitable, but if your profit is not converted to cash you may find yourself unable to service interest or principle payments on debt.

Do you have a handle on your debt? If not, AimCFO would love to help you begin this process.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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