background
Welcome to Wall Street Prep! Use code at checkout for 15% off.
Wharton & Wall Street Prep Certificates
Now Enrolling for February 2025 for September 2024
:
Private EquityReal Estate InvestingFP&A
Wharton & Wall Street Prep Certificates:
Enrollment for February 2025 is Open
Wall Street Prep

Cash Coverage Ratio

Step-by-Step Guide to Understanding Cash Coverage Ratio

Join 750k+ learners today. Learn online from Wall Street Prep — the training firm that prepares new hires at the world's top financial institutions.

Enroll Today

Cash Coverage Ratio

  Table of Contents

How to Calculate Cash Coverage Ratio

The cash coverage ratio is a variation of the interest coverage ratio, where the interest expense is inclusive of only the cash component.

To clarify, interest expense—the cost of borrowing capital (i.e. cost of debt)—can be structured in the form of either cash, paid-in-kind (PIK) interest, or mixture of the two.

The borrower of debt capital, such as a corporation, must pay interest to the lender on a periodic basis, as part of the financing arrangement.

However, PIK interest is not paid by the borrower in the period of recognition on the income statement. Instead, PIK interest accrues to the principal balance.

Therefore, practionioners like equity analysts and lenders often recognize that the interest expense recorded on the income statement does not reflect the actual interest burden.

The adjustment applied is thereby to exclude the PIK component, so that the interest expense used to perform credit risk analysis reflects the credit risk of a particular borrower more accurately.

While PIK interest is seldom a significant portion of the interest burden, the slight alternation to the formula is not time-consuming and relatively easy to compute.

The step-by-step process to calculate the cash interest expense is as follows:

  • Step 1 ➝ Calculate Total Interest Expense
  • Step 2 ➝ Deduct Interest Income from Total Interest Expense
  • Step 3 ➝ Subtract PIK Interest from Total Interest Expense, net
  • Step 4 ➝ Divide EBITDA (or EBIT) by Cash Interest Expense

Cash Coverage Ratio Formula

The cash coverage ratio formula divides EBITDA by the cash interest expense.

Cash Coverage Ratio = EBITDA ÷ Cash Interest Expense

Where:

  • EBITDA = EBIT + D&A
  • Cash Interest Expense = Interest Expense — PIK Interest

Conversely, the cash coverage ratio can be calculated by dividing EBIT (or “Operating Income”) by the cash interest expense.

Cash Coverage Ratio = EBIT ÷ Cash Interest Expense

Where:

  • Operating Income (EBIT) = Gross Profit – Operating Expenses (SG&A)
  • Cash Interest Expense = Interest Expense — PIK Interest

The cash coverage ratio in which EBIT is used in lieu of EBITDA is perceived as more conversative, since non-cash charges (D&A) are removed.

However, the decision to utilize EBIT, rather than EBITDA, is a bit counterintuitive to the underlying rationale to even use the cash coverage ratio in the first place.

Why? Non-cash charges, like depreciation and amortization(D&A), reduce operating income (EBIT), despite the fact that those expenses are non-cash items.

EBITDA adds back non-cash expense to remove the effects of non-cash expense, like D&A, which aligns with the purpose of the cash coverage ratio.

The third and final variation that we’ll discuss here uses cash and cash equivalents and free cash flow (FCF) in the numerator.

Cash Coverage Ratio = (Cash and Cash Equivalents + Free Cash Flow) ÷ Cash Interest Expense

Where:

  • Free Cash Flow (FCF) = EBITDA – Capital Expenditures (Capex) – Cash Taxes

Unlike the EBITDA variation, the free cash flow (FCF) is much more time-consuming to calculate, and requires collecting more financial data.

While more complicated, the output (and insights derived) are normally not too different; hence, the EBITDA variation is used more frequently.

Furthermore, the prior two variations that utilize operating metrics—EBITDA and EBIT—focus on operating performance, while disregarding the cash balance.

In contrast, the cash coverage ratio that uses free cash flow (FCF) includes the cash and cash equivalents of a company, which can be misleading because cash can be raised via equity and debt issuances (i.e. artificially inflated).

Cash Coverage Ratio Calculation Example

Suppose we’re tasked with calculating the cash coverage ratio of a company given the following historical income statement data.

Income Statement ($ in millions) 2024A
Revenue $10,000
Cost of Goods Sold (COGS) (6,000)
Gross Profit $4,000
Selling, General & Administrative (SG&A) (2,000)
Research and Development (R&D) (500)
Depreciation and Amortization (D&A) (500)
Operating Income (EBIT) $1,000
Interest Expense (Cash) (500)
Paid-In Kind Interest (PIK) (100)
Pre-Tax Income (EBT) $400
Income Tax Expense (100)
Net Income $300

In actuality, the income statement prepared under U.S. GAAP does not recognize the cash and PIK interest components separately.

However, for illustrative purposes, we’ve broken out interest expense, as well as depreciation and amortization (D&A).

The D&A expense is embeded within the cost of goods sold (COGS) and operating expenses (Opex) section of the income statement, and must thereby be obtained from the cash flow statement (CFS), where D&A is treated as a non-cash add-back.

EBITDA is equal to operating income (EBIT) plus depreciation and amortization (D&A), which comes out to $1.5 billion.

  • EBITDA = $1 billion + $500 million = $1.5 billion

The cash interest expense—the difference betweeen total interest expense and PIK interest—is $400 million.

  • Cash Interest Expense = $600 million — $100 million = $500 million
  • Cash Interest Expense = $1.5 billion ÷ $500 million = 3.0x

Therefore, the company’s EBITDA is sufficient to cover its cash interest burden by 3.0x (or “turns”).


Learn Financial Modeling Online

Everything you need to master financial and valuation modeling: 3-Statement Modeling, DCF, Comps, M&A and LBO.

Learn More

The Wall Street Prep Quicklesson Series

7 Free Financial Modeling Lessons

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.