Let’s look at the example of the recently bankrupted US-based trucking company Yellow Corp.
Its EBITDA Interest cover ratio was as follows:
Although the ratio level was generally low, the conclusion could still be that there was enough money to service at least the interest expense.
And indeed, up until 2023 there was enough money to service interest payments.
But, was it sustainable?
Let’s have a look at the EBIT Interest cover over the years:
This looks much worse.
The conclusion would be – no, there was not enough money to service interest expenses.
And this was one of the red flags.
But, why do values of these two ratios differ that much?
The reason is depreciation.
Isn’t depreciation a non-cash expense?
Yes, it is, but companies operating in capital-intensive industries need to maintain their asset base to stay competitive. You can’t be a market leader in a trucking business without investment in trucks.
So, we take the depreciation as a proxy for maintenance Capex.
Coming to the starting question – which one of these two ratios is better?
In capital-intensive industries it is much better to use EBIT Interest cover because we cannot ignore the fact that companies have to invest to stay afloat.
In other types of industries, it might be perfectly fine to use EBITDA Interest cover.
I am not a fan of any of these ratios because they only look at a very small part of a much bigger picture.
The answer whether a company covers at least interest payments is relevant mostly to those who look to invest in bullet structures, meaning they intend to stay invested for a longer period of time. You might not want to stay invested long in restructuring cases.
These ratios lost their importance during the low interest rate era, however, this will likely change now.
So, if you intend to use the ratio as a financial covenant, focus on the EBIT interest cover in capital-intensive industries.
Yes, depreciation can be manipulated, but so can EBITDA too.
There are solutions how to define EBIT in lending agreements properly.
Should you wish to know more, feel free to get in touch.
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