One of the ways of tracking the health of any business, whether yours or one you’re interested in investing in is to track the ability of the income from normal business operations to cover the company’s debt.
In this measure, the commonly used measure is to divide EBITDA by interest payment. EBITDA stands for Earnings Before Interest, Taxes, Depereciation and Amortization which is basically the income of the business before all those normal annual expenses. So a company with $10 million in EBITDA, and $5 million in Interest payments thus has a debt coverage ratio of 2x.
My beef with EBITDA however, is two fold. The first is that counting income before depreciation and amortization is a bit of a dubious measure because any business that depends on physical assets like factories, airlines, real estate, vehicles etc must account for depreciation because the value of those assets are being lost with us. In the same way, any business depending on non-tangible assets like intellectual property and co that are being used have to be amortized to account for their use and continual loss of value. So with depreciation and amortization, the earnings power of the business is going down which has to be replaced or maintained in the form of capital expenditure.
My second beef is that depreciation and amortization as non-cash expenses, can be manipulated up or down which in turn affects what the eventual debt coverage number looks like.
So rather than EBITDA, I prefer to use EBIT which is earnings before interest and tax payments. For this measure, depreciation and amortization will have been deducted from the earnings, and fully disclosed which helps me to know if the method used to depreciate makes sense. Moreover, interest and tax payments are objective and determined by creditors and the government so it’s hard for companies to manipulate. So if a company has a high debt coverage under just EBIT, it’s a good and very conservative measure of a company’s ability to pay it’s debt.
For instance, if under EBITDA, a company has 2x debt coverage, but after taking out D & A, the company only has 0.6 debt coverage, then that is not good enough because the company cannot meet up with it’s interest payments and sacrifice the ability to upgrade and maintain it’s assets if not then it will eventually lose the ability to make money.
Now, going fully in this direction. A company with low ability to cover it’s debts may survive and even thrive during a period when there is a lot of credit available and interest rates are low. They can just keep borrowing to finance their debt payments without running into any issues. If the easy credit period lasts long enough, as it has during this last recovery, businesses like that may even be growing their earnings and booming along with everyone else.
However, all good things eventually come to an end. And that is where the problem lies. When credit dries up and interest rates shoot up, companies with low debt coverage suddenly find themselves swimming naked in low tide, which means they’re exposed for their real situation and they go belly up. This is what happened with Salomon Brothers during the real estate crisis. It’s something you have to be attentive to in your business and any investment you want to make.
Think about that and let me know your thoughts, especially if you’re a business owner or an investor I can get some insights from.
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