What the heck is EBITDA (pronounced Ebb-bit-da)? Although it may look like some sort of alphabet soup, it’s actually a popular measure of debt payment ability used by many lenders today. In plain English it is:
Earnings
Before
Interest
Taxes
Depreciation (and)
Amortization
To calculate this number, take your pre-tax profit and add back any interest expense, depreciation expense and amortization expense. The result, theoretically, gives you the cash available in your company to repay any long term debt. (There are balance sheet items that affect cash that do not show up in the EBITDA calculation.)
Two common uses for EBITDA are interest coverage and debt coverage calculations. For interest coverage, simply divide EBITDA by the total amount of interest paid this year. The formula is:
EBITDA
Total Interest Paid
Bankers and most creditors prefer this ratio to equal at least 2.0.
Interest coverage is also used with projections and new projects. In this case, use your projected pre-tax earnings before interest expense adding back your anticipated total depreciation and earnings for Projected EBITDA. Divide this amount by the projected total interest for the year including the interest on any new loans. Therefore, the formula is:
Projected Annual EBITDA
Projected Annual Interest Expense
Remember to include interest on any working capital lines. Line amounts often increase with new sites, customers or projects. Lenders will want this ratio to be no less than 2.0.
For debt coverage, lenders use a variety of ratios using EBITDA. One of the most common ratios is EBITDA divided by total loan payments. The formula is:
EBITDA
Principle + Interest Payments
Most lenders are looking for this debt coverage to calculate to 1.5 or greater. Again, with new projects, you will want to use projected earnings and projected debt payments. If the result using the projections falls below 1.5, you could have difficulty meeting loan payments. If the result is less than 1.0, your company’s cash flow is definitely not enough to meet the payments.
To solve this problem, consider stretching out your loan for a longer amortization or look for ways to improve the bottom-line profit. Never enter into a new loan transaction with debt coverage of less than 1.0.
Because many family businesses use leases for trucks and equipment rather than debt, many lenders use EBITDA in what many call a Fixed Charge Ratio. This ratio is calculated as follows:
EBITDA + Lease Payments
Principle + Interest + Leases
Lenders typically want a 1.5 minimum ratio, but some lenders will let this ratio slide to 1.2 before raising a fuss. They want you to have 150% of your lease payments, but know that is not always feasible, particularly with large fleet operations.
If your business is set up as a “C” Corporation, these ratios can fall below typical minimums, thus causing you problems with lenders if you are taking a large owner’s salary or bonus (done to avoid double taxation of retained earnings). With traditional lenders, you may be able to talk them into using a portion of your owner compensation if a portion of that compensation truly is discretionary and could stay in the business if needed to repay debt. If you need your entire amount of owner compensation, however, to meet your mortgage payment and put your children through college, don’t adjust your EBITDA ratio calculations. That money would not be available to meet lender debt payments.
Another variation that you may come across is EBIDA which is simply the after-tax measure of ability to meet debts. EBIDA can be used in any of the aforementioned formulas. On an after-tax basis as with EBIDA, lenders typically require all coverage ratios to be at least 1.0.
The debate of EBITDA versus EBIDA depends strictly upon your lender’s view of taxes. The pre-tax (EBITDA) formula is most common since the lenders feel this pre-tax calculation provides more consistency from year to year. (Tax rates fluctuate often on the whim of Congress.)
Since there are a multitude of interest and debt ratio variations in the lending marketplace, your best bet is to ask your lenders and potential lenders to supply you with their exact formulas and requirements.
If you need a new loan, you’ll immediately know which lenders are feasible for your package. For existing debt, by monitoring your ratios, you just may avoid a nasty “out-of-compliance” situation at year-end with your current lender.
