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interest-calcHaving looked at how EBIT and EBITDA can support an investor’s pursuit of understanding what kind of impact management’s decisions are having on a business’ revenue generating capabilities, it is important for us to take a moment to also look at some metrics that can also be used to counter-balance the income-bias that EBIT-based metrics create for us. By balancing the returns of EBIT(DA) against the costs associated with leverage and depreciation-based performance metrics, we can create a much more encompassing picture of exactly how it is that a company is being run.

The first metric that can be used to evaluate the cost implications of management’s decisions is called the Interest Coverage Ratio. The ICR defines the proportion of interest expenses that is covered by EBIT (ie. ICR = EBIT/Interest Expense). The lower the ratio, the more debt that a company is servicing, and the less ability it has to pay off its debts based on its incomes. In general, an ICR of less than 1.5 is considered to indicate that the company’s operational direction has overleveraged itself.

When looking at how the formula is built, it becomes apparent that a change in ICR is an effective metric for counter-balancing EBIT because of the way in which it takes the fundamental costs of debt into consideration against the metric itself. This results in a metric that demonstrates how it is that management’s preference for leverage has exposed it to risk in the hopes of boosting top-line performance. This means that, if ICR is decreasing while EBIT is increasing, management is taking on debt faster than it can earn its way out of it.

A second metric that can be used to counter-balance the top-line bias of EBIT(DA) is called the Enterprise Multiple. The EM effectively calculates the value of a company by taking the sum of its equity and debt, less its cash equivalents, and divides this number (known as the Enterprise Value) by EBITDA to create a ‘multiplier’. This multiplier serves to demonstrate how it is that a company’s earnings potential compares to its tangible valuation. In general, a low multiple will suggest that a company is undervalued, while a high one will suggest that it might be over-valued.

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However, for our purposes, the EM can be used in conjunction with ICR to identify a bubble in the price of the asset. In the event an investor identifies a company with a particularly attractive (ie. Low) EM in conjunction with a low ICR, it might be the case that the company is using a great deal of debt to puff out its Enterprise Value and EBIT in order to create the impression of growth.

These two metrics in conjunction serve to then prevent investors from falling into the sort of trap that investors have been falling into over and over again for years on end.