The interest coverage ratio is a financial tool that assesses a company’s ability to pay the interest owed from debts. It is computed by dividing the earnings before interest and taxes by the interest expense during the financial period. The interest coverage ratio is also commonly referred to as the times interest earned. Investors, lenders, and other creditors use the formula to evaluate its riskiness relative to the debt. For example, a lender would appreciate if their investment increased in value. A big part of that appreciation is set on the profits and efficiencies. Investors would like to see that their firm can pay their short term obligations on time.
However, a creditor utilizes the interest coverage to see if a business will support additional debt. If the company cannot pay the interests of its debts, it will not afford the principal payments as well. Creditors use this approach as a preview of the company’s capabilities so that it can judge lending.
The interest coverage ratio is calculated by dividing the earnings before interest and taxes, otherwise known as EBIT, by the interest expense.
Interest Coverage Ratio = EBIT / Interest Expense
Earnings before interest and taxation are the net income provided the interest and taxes are added. EBIT is used instead of net income. There is a need for a true representation of how much the business can afford in terms of interest. If there was net income, then the computation would be skewed, as interest expense would be accounted for twice. Taxation would also alter according to the interest deduction.
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Generally speaking, a low-interest coverage ratio means the company’s debt burden is particularly big, and there is a high possibility of bankruptcy in this setting. However, if the interest coverage ratio is high, then there is a low chance of defaulting. A low ratio signifies there are not enough profits available to meet the interest expenditure for the debt. If the business has a variable rate debt, the interest expense will increase within an environment of increased interest rate. A high ratio shows there are sufficient profits to help with the debt. It could also be one of the indicators the business is not using the debt in the right way. If the organization is not borrowing sufficiently, it might not be reinvesting in the new technologies to remain ahead of the competition.
The range that constitutes good interest coverage varies between the industries and businesses in the same sector. A ratio of at least 2 signifies a company has consistent returns. Analysts tend to prefer ratios that extend to 3 and above for a healthy prognosis. On the other hand, if the ratio is below one, it shows the business cannot meet the payment obligations, which shows it is not in good financial health.
Significance of the Interest Coverage Ratio
To get an accurate picture of the business’s ability to meet the financial obligation, interest coverage plays a great role. The interest coverage ratio shows the level of the firm’s ability to afford interest paid to companies for raising the debt. It does not consider the capability of making payments on the principal. Rather, it shows how much the business may afford to pay the interest on the debt. Investors are interested in the ratio because it would determine if the business can make payments on time without compromising the usual operations and the profits made. It also ascertains if it is risky or profitable to invest in the firm.
Factors that affect the Interest Coverage Ratio
- Operating expenses: if the operating costs are low, then the profit is going to be high. A high operating profit is going to mean a higher interest coverage ratio.
- Interest expenses: If it is possible to lower the company’s interest expenses, that will lower the denominator within the computation. That would show the company has a higher level of affording the interest expenditure, resulting in a high-level interest coverage ratio.
- Earnings before interest and after taxation: the designation is a variation utilized by some firms rather than the EBIT (Earnings Before Interest). It will depict a good scenario of the expenses of the company before paying off the interest expenses as taxes play a significant role in the company’s financial position, resulting in a lower interest coverage ratio.
- Gross profit: the higher the profit for the firm, the higher the operating profit. A large operating profit implies a high-interest coverage ratio.
Limitations of the Interest Coverage Ratio
Though the ratio may be widely used, it is not the ultimate tool to determine creditworthiness. It only looks at the interest payment schedule and trends. The interest coverage ratio does not tell the lender or investor concerning the business’s ability to pay back the principal that has been borrowed. Similarly, the numbers could have the ability to defer interest payments on loans to subsequent years. Should that be the case, the interest coverage ratio may overstate the business’s chance to optimize the interest obligations. Going forward, the financial cost may be understated.
Analysts also tend to use other tools to evaluate businesses. The debt service ratio considers the debts which are due within a year. The interest coverage ratio cannot be used solely to determine the financial health of a company.
At one time, the interest coverage ratio may assist the analyst concerning the firm’s ability to service the debt. However, analysis of the interest coverage ratio over a period will illustrate whether or not the debt is an issue on the company’s financial health. It is hard to predict the long term financial position based on just one tool. The desirability of the tool depends on the one that is using it. Some financial institutions may be comfortable with an interest coverage ratio that is less desirable in exchange for charging higher interest rates.