What Is Interest Coverage Ratio?

Financial ratios provide lenders and investors with critical information about a company's financial status.

The interest coverage ratio is an important financial number that indicates a company's ability to pay off its debt.

Interest coverage ratios have an impact on a company's ability to borrow money and assist investors in comprehending the risk of investing in its stock.

What Is Interest Coverage Ratio?

The interest coverage ratio is a debt and profitability ratio that determines how readily a corporation can pay interest on its debt.

The times interest earned (TIE) ratio is another name for the interest coverage ratio. This method is frequently used by lenders, investors, and creditors to assess a company's riskiness in relation to its present debt or potential borrowing.

Creditors, lenders, and investors use this metric to assess the risk of financing money to a company.

Divide a company's earnings before interest and taxes (EBIT) by its interest expense for a particular period to get the interest coverage ratio.

A high ratio suggests that a corporation can cover its interest expense multiple times over, whereas a low ratio signifies that a company is likely to default on its loan payments.

The term "coverage" in the interest coverage ratio refers to the amount of time, usually quarters or fiscal years, that interest payments may be paid with the company's present earnings.

In basic terms, it indicates how many times the company's earnings can be used to meet its financial obligations.

In order to withstand future, and maybe unanticipated, financial crises, businesses must have more than enough earnings to meet interest payments.

The ability of a corporation to satisfy its interest obligations is a measure of its solvency, and thus a key component in shareholder returns.

How important is Interest Coverage Ratio?

Any company's ability to stay afloat in terms of interest payments is a significant and continuous consideration.

When a firm is having trouble meeting its obligations, it may have to borrow more or utilize its cash reserve, which would be better spent on capital assets or for contingencies.

Although a single interest coverage ratio might disclose a lot about a company's current financial situation, looking at interest coverage ratios across time can frequently show a lot more about a company's position and future.

Examining a company's interest coverage ratios quarterly for the past five years, for example, can tell investors whether the ratio is improving, dropping, or stable, and can give you a good idea of how healthy its short-term finances are.

Furthermore, the acceptability of any specific level of this ratio is, to some extent, in the interest of anyone looking at it.

Most banks or prospective bond buyers may be willing to accept a lower ratio in exchange for a higher interest rate on the company's debt.

Interest Coverage Ratios of Different Types

Before looking at company ratios, it's vital to know two typical versions of the interest coverage ratio.

Adjustments in EBIT are the source of these differences.

1. Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA)

When computing the interest coverage ratio, one alternative utilizes earnings before interest, taxes, depreciation, and amortization (EBITDA) instead of EBIT. 

Since this variation removes depreciation and amortization, the numerator in EBITDA estimates is frequently higher than in EBIT calculations.

Because the interest expense would be the same in both circumstances, EBITDA calculations will result in a larger interest coverage ratio than EBIT calculations.

2. Earnings Before Interest After Taxes (EBIAT)

In another form, the interest coverage ratio is calculated using earnings before interest after taxes (EBIAT) rather than EBIT.

This has the effect of subtracting tax charges from the numerator and results in a more accurate depiction of a company's ability to meet up to pay interest expenses.

As taxes are a significant financial factor to consider, EBIAT can be used to compute interest coverage ratios instead of EBIT to get a better view of a company's capacity to meet its interest expenses.

How to calculate Interest Coverage Ratio

This formula can be used to compute interest coverage ratios:

Interest coverage ratio = EBIT ÷ interest expense

Earnings before interest and taxes, or EBIT, is also known as operational profit or operating income. The interest expense is the amount of interest paid on the company's obligations over a specific time period.

Since EBIT is a more accurate measure of how much money a company has sufficient to pay interest, the interest coverage ratio uses EBIT instead of net income.

Because net income represents a company's earnings after taxes and outstanding interest, using its net income to determine its interest coverage ratio would double-count a company's interest expenses.

You must first ascertain a company's EBIT and interest expenses before calculating its interest coverage ratio.

These data can be found in the company's most recent income statement, which is required to be filed with the U.S Securities and Exchange Commission as one of the company's annual reports.

This data is available on EDGAR (The Electronic Data Gathering, Analysis, and Retrieval system), which is the Securities and Exchange Commission's public database.

On an income statement, EBIT is often referred to as operating profit or operating income.

Simply enter the company's EBIT and interest expenses into the formula once you've found it.

Also, you obtain the interest expense for the corporation, which is the interest paid on borrowings such as lines of credit, bonds, and loans.

The entire interest expense for a certain period is normally shown on the income statement of the company. This figure does not include a company's total debt repayment, which can be found on its balance sheet.

Example of how to Calculate Interest Coverage Ratio

In the most recent reporting month, a company's earnings were $7,000,000 before interest and taxes.

That month's interest expense was $3,500,000.

As a result, the interest coverage ratio of the company is computed as follows:

$7,000,000 ÷ $3,500,000

= 2.

According to the ratio, the company's earnings should be sufficient to cover the interest expense.

An interest coverage ratio of 1.5, on the other hand, is usually regarded as a minimum acceptable ratio for an organization and the point below which lenders will probably refuse to offer the company more money because the risk of failure to pay is considered to be too large.

When a company's ratio is less than one, it will either have to spend part of its cash reserves or get more loans, which will be challenging for the reasons described above.

Or else, the company risks going bankrupt even if earnings are low for a single month.

Uses of Interest Coverage Ratio

  • Lenders, creditors, and investors use the ICR to assess the risk of lending money to a company.

  • The ICR is used to assess a company's short-term financial health.

  • The ICR is used to determine a company's ability to pay interest on existing debt.

  • The ICR trend analysis provides a clear view of a company's interest payment stability.

  • It is used to assess a company's financial stability; a falling ICR indicates that a corporation may be unable to satisfy its debt obligations in the future.

Purpose of an Interest Coverage Ratio for different Users

Interest coverage ratios are used by accountants and investors to assess a company's short- and long-term financial health.

Lenders use this financial ratio as a litmus test to determine whether or not a company will be able to repay a loan.

Lenders can also utilize a company's ICR to calculate the interest rate on any loans that are requested.

Similar financial ratios are also used by businesses to determine if they are taking full advantage of debt opportunities or taking on too much debt.

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