How to make money in stocks. Lesson 29. EBITDA/Interest coverage. VISA

In Lesson 23, we went over the Interest Coverage Ratio (ICR) financial indicator using EBIT. Given that this metric is extremely helpful, let’s take a deep dive into ICR using EBITDA as an example.

• ICR helps you find out how easily a company can meet the interest on the outstanding debt.
• Investors or lenders employ ICR to assess capital risks.
• In a way, ICR enables you to see whether a company is stable: the drop in ICR suggests that a company may be unable to meet its long-term financial obligations.
• ICR is a useful metric for assessing the short-term financial position of a company.
• Assessing ICR over time gives an idea of whether a company is stable in terms of interest payments.
• Also, ICR is sometimes referred to as Times Interest Earned Ratio.

✅ Average interest rate on deposits per annum — 10 %

✅ Trader’s average annual profitability — 50-100 %

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Calculation formulas

Components:

• For EBIT, see Lesson 24
• For EBITDA, see Lesson 25
• IInterest Expenses are the interest that’s payable on any loans, lines of credit, etc. It’s one of the key expenses in the income statement. Interest is often a separate line item under the operating income

Real-world case VISA Inc. #V

1. #V EBIT for the quarter ended in December 2020 totals:

EBIT = Net Income + Taxes + Interest = $3,126 + $622 + $96 = $3.844

2. #V EBITDA for the quarter ended in December 2020 totals:

EBITDA = Net Income + Taxes+ Interest + Depreciation + Amortization = $3,126 + $622 + $96 + $197 = $4,041

3. #V Interest Expenses for the quarter ended in December 2020 totals ($136)

(See Figure 1)

4. Option 1: Use of EBIT

#V Interest Coverage Ratio for the quarter ended in December 2020 totals:

EBIT / Interest Expenses = $3,844 / $136 = 28.26

Here’s the bottom line: Visa’s ICR for the quarter ended December 2020 was 28.26. This means that Visa can cover interest payments 28 times using earnings before interest and taxes. The higher the ratio, the more stable the company.

5. Option 2: Use of EBITDA

Interest Coverage Ratio #V for the quarter ended in December 2020 totals:

EBITDA / Interest Expenses = $4,041 / $136 = 29.71

The bottom line is similar: Visa can cover interest payments 29 times using earnings before interest, taxes, depreciation and amortization.

6. Let’s compare the ICR of the financial services companies that have large market capitalization:

• MasterCard Inc. #MA 21.48.
• PayPal Holdings #PYlPL 16.40.

When comparing its ICR with MasterCard, its key competitor, over five years, we can see that Visa slightly increased its ICR and looked more stable, while MasterCard had a decreased ICR, which may be a signal of liquidity problems in the future.

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Subtle calculation aspects

1. If interest expenses are negative, while the operating income is positive, you should use the usual formula.
2. If interest expenses and operating income are negative, a company has no income to pay interest.
3. If interest expenses equal and long-term debt equal “0”, a company didn’t have any loans.

EBITDA limitations

Let’s assume that a company’s EBITDA/Interest Coverage is 1.30. This figure can’t clearly confirm that a company can cover its interest payments. Since EBITDA doesn’t include depreciation and amortization costs, 1.30 figure won’t help you measure the final stability. The reason for it is that a company must spend a significant portion of its income on replacing fixed assets, etc

Let’s sum things up

This metric is a reliable tool designed for analyzing whether a company can cover interest expenses. It’s relevant to use ICR when you analyze a company over time, in a single industry and when coupled with other multiples..

⇐ How to make money in stocks. Lesson 28. NET DEBT/EBITDA. Intel     Key to making money with shares. How to pick stocks ⇒

Useful articles:

• Specifics of Stock Market Trading

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