Interest coverage ratio

In the following article, we will discuss everything there is to know about interest coverage ratio, including its formula, importance, and types. We will also go over an interest cover ratio example.

What is the interest coverage ratio?

The interest coverage ratio is a debt and profitability ratio. It assesses whether a business can easily cover the interest on its existing debt. To calculate the interest coverage ratio, use the special formula described below. Creditors and investors use this formula to determine whether a company’s risk of default on current debt or future loans is high.

Formula

The formula for calculating the interest coverage ratio is simple; you must divide the company’s earnings before interest and taxes (EBIT) by the interest expense for a specific period.  

Interest Coverage Ratio = EBIT / Interest Expense

Key takeaways

• The ability of a company to pay off the interest on current loans is gauged using the interest coverage ratio.
• The interest coverage ratio is also called the Times Interest Earned ratio (TIE).
• Instead of using EBIT to determine the ratio, other implementations of the method utilize EBITDA or EBIAT.

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Understanding the interest coverage ratio

The term “coverage” in the interest coverage ratio relates to the fiscal years or quarters during which interest payments may be met using the company’s present cash inflow. It demonstrates how frequently the corporation can meet its financial obligations.

The smaller the ratio, the greater the firm’s debt-related costs are and the less cash it has available for other uses. A company’s capacity to cover interest costs may be doubtful if its interest coverage ratio is below 1.5.

Importance of the interest coverage ratio

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Any business must constantly and critically worry about making interest payments. When a company has trouble meeting its obligations, it will have to take on additional debt or utilize cash reserves, which would be far better invested in capital investments or kept on hand for crises.

Examining the interest coverage ratio can provide valuable information not only about a company’s current financial position but also give a more accurate picture of its status and future. A company’s ability to meet its interest-bearing obligations is an indicator of its solvency and an important return factor for shareholders.

Investors may determine if a firm’s interest coverage ratio is rising, falling, or has remained consistent by looking at it quarterly, for example, the last five years. This is a great way to gauge a company’s short-term financial condition.

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Example of the interest coverage ratio

Consider a company that earned $525,000 in income during a specific quarter and owes loans that need payments of $20,000. The monthly interest charges would need to be multiplied by three to become quarterly payments before calculating the interest coverage ratio. 

The company’s interest coverage ratio is $525,000 / $60,000 ($20,000 x 3), which is 8.75. This suggests that the firm is not currently experiencing any liquidity issues.

The turning point under which creditors are most likely to decline to grant the company additional money because its risk for bankruptcy may be viewed as significantly high is commonly thought to correspond to an interest coverage ratio of around 1.5.

If a company’s ratio is less than one, it will either have to borrow additional money or use part of its cash holdings, which will be challenging for the reason mentioned above. If not, the business runs the danger of going bankrupt even if profits are poor for just one month.

Types of interest coverage ratios

Before examining the ratios of companies, it is crucial to consider two common variants of the interest coverage ratio. These changes result from modifications to EBIT.

EBITDA

One such version calculates the interest coverage ratio using earnings before interest, taxes, depreciation, and amortization (EBITDA) rather than EBIT. EBITDA calculations often have a bigger numerator than EBIT calculations since this variant does not include depreciation and amortization. 

EBIAT

Liquidity Adjustment Facility (LAF)

Another alternative substitutes EBIT with earnings before interest after taxes (EBIAT) for calculating interest coverage ratios. It has resulted in removing tax payments from the numerator to give a more true image of a firm’s capacity to pay its interest charges.

Limitations of the interest coverage ratio

The interest coverage ratio has several limitations that every investor should be aware of before utilizing it. One of the main drawbacks is that interest coverage varies significantly when comparing companies across sectors. An interest coverage ratio of 2 is sometimes considered to be an acceptable benchmark for well-established businesses in specific sectors, like a utility company.

FAQ

Here we will discuss the key questions about the interest coverage ratio.

What does the interest coverage ratio tell you?

The interest coverage ratio measures a company’s ability to manage its outstanding debt and assess its financial health.

How is the interest coverage ratio calculated?

The ratio can be calculated by dividing EBIT by interest expenditures (the price of borrowed money) over a specific period, often a year.

What is a good interest coverage ratio?

A ratio over one shows that a business can pay its loans’ interest using profits or has demonstrated the capacity to keep earnings around the same level over time. While an ICR of 1.5 could be the bare minimum acceptable, investors and analysts prefer a ratio of two or higher.

What does a bad interest coverage ratio indicate?

Any value below one is considered a bad ICR since it indicates that the firm’s existing profits are incapable of paying off its debt. Even with an ICR of 1.5, it’s still unlikely that a business would be able to pay its interest costs continuously, notably if it is susceptible to periodic or cyclical income fluctuations.

The bottom line 

Both companies and lenders benefit in one manner or another from the interest coverage ratio. Using it, the lenders can determine the company’s financial stability and capacity to make interest payments on schedule. Therefore, the simpler it is for the debtors to balance their interest payments over several loans, the greater the ratio.

The interest coverage ratio is used in trend analysis, the process through which a business examines its financial records to identify trends. It helps them understand historical patterns and allows them to predict future developments. Companies are given a chance to improve their performance over time.