Interest Coverage Ratio – Accounting Superpowers

Interest Coverage Ratio

Interest Coverage Ratio

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.)

FORMULA:

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.

1. While the Interest Coverage Ratio is a good indicator of a companies ability to pay its debt at a given point in time, it is especially useful when you use it to compare the companies performance over a particular period.

As an example, if a companies interest coverage ratio has dipped from 4x to 1.5x over a period of time - it indicates that the company has taken on more debt.

A smart analyst or investor would take this knowledge and go one step further and ask questions like -

- Why did the company take on more debt?

- Did it make any capital expenditures with the debt and how will those expenditures increase Revenue in the future?

- Was the debt taken on because the company is having cash flow issues?

- Did management give itself big bonuses with the company debt? 

2. If all else is relatively equal, the interest coverage ratio can also be very useful when comparing two companies in the same industry. The company with the lower interest coverage ratio may not be able to sustain downturns as well as the company with a high interest coverage ratio.

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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