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What is interest coverage ratio?
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What Is Interest Coverage Ratio
The interest coverage ratio, as its name suggests, allows you to calculate how well a company can pay interest on its debt obligations.
In other words, this ratio provides information as to a company’s ability to cover its debt obligations as they come due.
The more a company is able to cover the interest on its debt, the less risk investors perceive.
However, if a company does not have enough revenue to cover its interest obligations, then investors perceive additional risk.
It’s important for a company to be able to cover its debt to avoid defaulting on its obligations.
When a company’s debt obligations increase or revenues drop, its interest coverage ratio will show great signs of risk.
You can calculate the interest coverage ratio by taking the company’s earnings before interest and taxes and dividing it by its interest expense for the period.
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Why Is Interest Coverage Ratio Important
The interest coverage ratio is a measure of a company’s solvency.
Every company borrowing money must respect its debt obligations.
As a result, companies must ensure that they can pay the principal and interest as per the terms of their loan agreements or financing contracts.
It is crucial for a company to pay its debt obligations on time to avoid triggering default provisions leading to creditors taking action against the company.
When a company does not generate enough revenues to pay the interest on its debt obligations, this is a sign that there are solvency issues on the horizon.
To avoid defaulting on its debt, a company may need to reduce its working capital, postpone its capital investments, or scale business down to be able to use its cash reserves to pay its debt on time.
When you look at a company’s interest coverage ratio at a given point in time, you can see how many times a company is able to cover its debt.
When you look at a company’s interest coverage ratio over a period of time, you can see whether or not the company is stable, doing better, or doing worse.
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Interest Coverage Ratio Formula
The interest coverage ratio can be calculated using the following formula:
Interest Coverage Ratio = EBIT / Interest Expense
As you can see, the company’s earnings before interest and taxes (EBIT) is divided by the company’s interest expense.
For instance, if a company has an EBIT of $1,000,000 and interest expense of $100,000, the ratio will come out to 10.
This means that with the company’s current income, it is able to “cover” ten times its interest obligations.
Investors, financial analysis, and professionals calculate the interest coverage ratio as it provides them valuable information about the solvency of a company.
A company that has a ratio that is very low may have difficulty paying interest on its debt obligations.
On the other hand, a company that has good interest coverage will be able to not only manage its interest expenses but is better prepared for market shifts and unexpected changes in market conditions.
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Interest Coverage Ratio Interpretation
The interest coverage ratio is a measure of a company’s ability to pay for its interest expenses during a given accounting period.
Let’s say a company has revenues of $500,000 in a given quarter and has to pay $75,000 in interest expenses.
The company’s interest coverage ratio will come out to 6.67.
In other words, for every $1 of interest that the company is obligated to pay, it is generating $6.67 in revenues.
If you look at the ratio, without considering anything else, it appears that the company has good solvency as it has six times more revenues than the interest it has to pay.
However, if you look at its peers and they have an average interest coverage ratio of 15, you should start continue your investigation to understand why this company is below average.
Alternatively, if the peers are at 3, this means that the company has more revenues to cover for its interest expenses.
Typically, a ratio of 1.5 is the minimum acceptable ratio which.
If the interest coverage ratio is below 1.5, investors and analysts will be concerned.
Also, banks and lenders will no longer extend credit as easily or based on preferential rates.
Interest Coverage Ratio Limitations
Just like most other financial ratios and measures, the interest coverage ratio does have some limitations.
The most notable limitation is that a company’s interest coverage ratio should be considered in relation to companies having a similar business model.
Companies in the same industry may have different interest coverage ratios and it may be difficult to reliably compare them.
As a result, to really assess a company’s interest coverage ratio compared to its competitors, you’ll need to find companies that have a similar business model and of similar size.
Another important limitation of interest coverage ratio is that different stakeholders may consider a different type of debt in their calculation.
If the interest coverage ratio does not include all debt obligations, the ratio will show the company in a better light.
Also, the interest coverage ratio is a ratio that is calculated at a specific point in time.
If there are sudden changes in market conditions, you need to consider that in your assessment.
Interest Coverage Ratio Example
Let’s look at an example of the interest coverage ratio to illustrate the concept better.
Let’s assume a company has quarterly earnings before interest and taxes of $100 million.
Also, the company is required to pay interest on its debt in the amount of $10 million per month.
The company’s interest coverage ratio is calculated by taking the company’s EBIT and dividing it by its interest expense.
Since interest expense is expressed on a monthly basis, it company has to assume $30 million in interest expense in a calendar quarter.
As a result, the company’s interest coverage ratio is $100 million / $30 million = 3.33.
This means that the company has earnings before interest and taxes of $3.33 for every $1 interest expense.
Since this ratio is above 1.5, it appears to meet the minimum acceptable standards.
However, it’s useful to compare this ratio with other companies in the same industry, particularly those having the same business model and of similar size to see if this ratio fares well or not.
Interest Coverage Ratio FAQ
What is a good interest coverage ratio?
Although you will need to look at the industry and the company’s business model to see what should be a good interest coverage ratio, many investors consider a ratio of 1.5 is the minimum acceptable ratio.
The higher the ratio, the more the company generates revenues to cover its interest expenses.
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How do you calculate the interest coverage ratio?
You can calculate the interest coverage ratio by dividing a company’s earnings before interest and taxes by its interest expenses for a given period.
For instance, if a company that has an EBIT of $100,000 revenues per month and has to pay $15,000 in interest, you can calculate its interest coverage ratio
What are the different types of interest coverage ratio?
There are different variations of interest coverage ratio that could be calculated.
The interest coverage ratio is generally calculated using the earnings before interest and taxes (EBIT).
However, you can also use earnings before interest, taxes, depreciation, and amortization (EBITDA).
You can also use earnings before interest after taxes (EBIAT) to calculate the interest coverage ratio.
Takeaways
So there you have it folks!
What is interest coverage ratio?
In a nutshell, the interest coverage ratio is a financial measure of a company’s solvency allowing you to see how well a company is able to pay interest on its outstanding debt.
You can calculate interest coverage ratio by taking a company’s EBIT and dividing it by Interest Expenses.
When a company’s interest coverage ratio is very low, it means that the company has a greater level of debt burden increases the risk of insolvency or bankruptcy.
However, a ratio that is high shows the company has sufficient revenues allowing it to adequately cover its debt obligations without running any default risk.
Now that you know what interest coverage ratio means and how it works, good luck with your research!
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