Introduction

The interest coverage ratio is one of the most essential parameters to gauge a company’s capacity to pay off its debts. It is used by investors, lenders and creditors to evaluate the company’s financial health they have invested lent money to. Using the metric, they can know the borrowing firm's profitability and avoid any risk of default.

Open Your free Demat Account in just 5 minutes!

What is the interest coverage ratio?

The interest coverage ratio is a financial metric used to determine the number of times an organization can pay the interest due on its debts with its current earnings. It is calculated before applicable interest and taxes are deducted.

In other words, the interest coverage ratio helps know how easily a company can pay off the interest due on its debt. It is a debt-to-profitability ratio, sometimes called 'times interest earned'.

It is important to remember that the interest coverage ratio does not take into account the principal amount but only the interest accumulated on it.

Now that you know the interest coverage ratio, here’s how it is calculated.

Calculation of interest coverage ratio

The interest coverage ratio is computed by dividing a company's earnings before taxes and interest expenses by its interest obligations in the same period.

Here’s the formula to calculate the interest coverage ratio:

Interest coverage ratio = Earnings Before Taxes and Interest (EBIT)/ Interest expense

Or,

Interest coverage ratio = EBIT + Non-cash expenses/ Interest expense

Where;

• EBIT refers to the company’s operating profit
• Non-cash expenses include amortization and depreciation
• Interest expense is the interest paid on debts like loans, bonds, lines of credit and other borrowings

What does the ratio signify?

The desirable interest coverage ratio can be different for every industry. However, the following points can help you analyze the metric better:

• Less than 1

An interest coverage ratio of less than one suggests the borrowing firm is not generating enough profits to fulfill its interest obligations.

• Below 1.5

An interest coverage ratio below 1.5 reflects a high chance the borrowing firm may be unable to pay off interest on its debt obligations.

• Between 2.5 and 3

An interest coverage ratio between 2.5 and 3 indicates that the borrowing firm will easily pay off its interest obligations with available earnings.

The values mentioned above can vary from industry to industry. A ratio that is considered good for one industry may not be sufficient for another.

For example, sectors like natural gas, electricity, or other utility services usually have a low-interest coverage ratio. However, a high ratio is essential for industries like manufacturing, technology, consumer goods, etc.

Why does the interest coverage ratio matter?

The interest coverage ratio is an essential metric for the following reasons:

• The interest coverage ratio acts like a solvency check for a firm
• It helps lenders, investors, and creditors gauge a company’s financial stability when it comes to repayment of interest on debt
• The ratio also helps investors, employees, and creditors evaluate a company’s profitability and make informed decisions
• It helps in assessing the creditworthiness of a firm before lending to it

Limitations of the interest coverage ratio

The interest coverage ratio can have the following limitations:

• The ratio may not help forecast a company’s long-term financial status
• It does not take into consideration the seasonal variations and may not depict a firm’s accurate financial health
• The interest coverage ratio does not consider the impact of tax expenses
• The ratio varies from industry to industry. This makes it difficult to compare the profitability of companies belonging to different sectors

Conclusion

The interest coverage ratio is a valuable metric for lenders and investors who wish to invest in a company. A low ratio indicates that the company is burdened by its debt obligations. It also indicates a greater possibility of bankruptcy or default, which hurts the company’s goodwill.

However, the interest coverage ratio is not the sole criterion to gauge a firm’s financial standing. It should be used with other metrics like cash ratio, current ratio, debt-to-equity ratio, etc., to make a more informed decision.

Related Articles:   What is Span and Exposure Margin | What is Evening Star Candlestick Pattern | Difference Between Margin Trading And Short Selling | What is trading on equity