If you had a crystal ball and could see only one ratio in the foreseeable future of a company - the interest coverage ratio may not be a bad one to pick.
The Interest coverage ratio is a Financial Ratio that reflects a company's ability to pay interest on its outstanding debt.
Investors and analysts often use this ratio to reflect how safe a company is and how much of a decline in earnings can a company absorb.
The interest coverage ratio is calculated by taking the Earnings before interest and taxes (EBIT) and dividing it by the Interest Expenses that a company has incurred over a period (Both these numbers can be found in the Income Statement.)
Interest Coverage Ratio = EBIT / Interest Expense
For example, if a company's earnings before taxes and interest amount to $100,000, and its interest payment requirements total $25,000, then the company's interest coverage ratio is 4x.
The interest coverage ratio may also be referred to as the times interest earned ratio.
What is a good interest coverage ratio?
An interest coverage ratio above 2 is acceptable and an interest coverage ratio of less than 1.5 may be considered questionable. The lower the ratio, the more the company is burdened with interest expenses.
For more insights on important financial ratios, check out our complete article on Ratio Analysis.
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