254  Analyzing Performance value: a company’s return on invested capital and organic revenue growth. In the final step of historical analysis, we focus on how the company has fi- nanced its operations. What proportion of invested capital comes from credi- tors instead of from equity investors? Is this capital structure sustainable? Can the company survive an industry downturn? How much cash, if any, has been distributed to shareholders? To assess a company’s capital structure, conduct four analyses. First, exam- ine liquidity using coverage ratios. Liquidity measures the company’s ability to meet short-term obligations, such as interest expenses and rental payments. Next, evaluate leverage using debt to EBITDA and debt to value. Leverage measures the company’s ability to meet obligations over the long term. To evaluate equity, measure the payout ratio and operating value to EBITDA. The payout ratio measures the percentage of income being sent to shareholders. Operating value to EBITDA measures shareholders’ future expectations of financial performance. This section introduces the tools for evaluating a company’s capital struc- ture. Chapter 33 examines how capital structure decisions must be an integral part of a company’s operating strategy and its plan for how it will return cash to shareholders. Measuring Liquidity Using Coverage Ratios To estimate the company’s ability to meet short-term obligations, analysts use ratios that incorporate three measures of earnings: 1. Earnings before interest, taxes, and amortization (EBITA) 2. Earnings before interest, taxes, depreciation, and amortization (EBITDA) 3. Earnings before interest, taxes, depreciation, amortization, and rental expense (EBITDAR) With the first two earnings measures, you can calculate interest coverage. To do this, divide either EBITA or EBITDA by interest. The first coverage ratio, EBITA to interest, measures the company’s ability to pay interest using profits without cutting capital expenditures intended to replace depreciating equip- ment. The second ratio, EBITDA to interest, measures the company’s ability to meet short-term financial commitments using both current profits and the depreciation dollars earmarked for replacement capital. Although EBITDA provides a good measure of the short-term ability to meet interest payments, most companies cannot compete effectively without replacing worn assets. An alternative is to divide EBITDAR by the sum of interest expense and rental expense. Like the interest coverage ratio, the EBITDAR ratio measures the company’s ability to meet its known future obligations, including the ef- fect of operating leases. For many companies, especially retailers and airlines, Credit Health and Capital Structure  255 including rental expenses is a critical part of understanding the financial health of the business. Returning to our previous example of Costco and its peers, Exhibit 12.11 presents their financial data and coverage ratios. For 2018, Costco’s coverage ratio of EBITA to interest equaled 31.6 times, whereas its peers had a ratio of 15.3 times. By most standards, Costco has very little debt, which is reflected in its extremely high AA– rating by Standard & Poor’s. Costco’s peers also have small amounts of leverage and high debt ratings, but to a lesser degree. Measuring Leverage Over the past decade, interest rates have dropped to unprecedented lows, making interest coverage ratios uncharacteristically high. To evaluate leverage in this low-interest-rate environment, many analysts are now measuring and evaluating debt multiples such as debt to EBITDA or debt to EBITA. Given its much larger denominator, debt to EBITDA tends to be more stable, making assessments over time much clearer. The ratio also does a better job of teasing out companies that are exposed to rollover risk and widening default spreads, neither of which is captured when interest rates are extremely low. A second reason the debt-to-EBITDA measure has gained in popularity in- volves the increased use of convertible securities. Many convertibles compen- sate through the potential conversion to equity rather than interest, making EXHIBIT 12.11  Costco versus Peer Group: Measuring Coverage $ million Costco Peer Group 2016 2017 2018 2016 2017 2018 EBITA 4,111 4,480 4,737 EBITDA 5,481 5,917 6,229 EBITDAR1 5,739 6,182 6,497 Interest 134 159 150 Rental expense 258 265 268 Interest plus rental expense 392 424 418 Coverage ratios EBITA/interest 30.7 28.2 31.6 9.0 8.3 15.3 EBITDA/interest 40.9 37.2 41.5 13.1 12.7 19.8 EBITDAR/interest plus rental expense 14.6 14.6 15.5 5.2 4.7 4.8 Debt multiples Debt to EBITA 1.71 1.56 1.53 2.21 2.35 2.40 Debt to EBITDA 1.28 1.18 1.16 1.53 1.53 1.67 Debt plus leases to EBITDAR 1.67 1.53 1.49 2.55 2.63 2.72 1 Earnings before interest, taxes, depreciation, amortization, and rental expense.