What is an Interest Coverage Ratio?
It is a financial metric that ascertains the number of times the company can pay off the interest accumulated before applying taxes and interest is deducted. The ratio is popularly known as times interest earned. It does not account for the repayment of the principal debt but only the interest that is accumulated.
Understanding what the Ratio Means
The lower the interest coverage ratio, the more the company is burdened by debt expense. A ratio that is less than one means the company is struggling to fulfil its interest obligations. A ratio below 1.5 indicates that there is the high probability that the company will not be able to meet its interest obligations. A ratio between 2 to 3 shows that the company will be able to pay off the accumulated interest on debt with its current earnings easily. But one needs to keep in mind that these values are also industry specific. For example, a low interest coverage ratio is acceptable in essential utility services such as electricity, oil etc. but for industries such as technology, manufacturing fast moving consumer goods etc., the company must have a high interest coverage ratio.
How is Interest Coverage Ratio Calculated?
The ratio is mathematically calculated as follows – Interest Coverage Ratio = Company's EBIT + non-cash expenses/ Company's interest expenses for the same period. Please note that the company’s EBIT is the company’s operating profit, the non-cash expenses include depreciation and amortization charges and interest expense includes the interest paid on borrowings.
Use of Interest Coverage Ratio
Interest coverage ratio serves as a solvency check for an organization. It allows investors, financial institutions and the market to understand the current ability of the firm to pay accumulated debts. It is also used to assess the profitability of the firm. Lenders use it to evaluate the credit worthiness of the company. Limitations of Interest Coverage Ratio It is not easy to forecast a company’s long term financial standing with the help of this ratio. The ratio does not account for seasonal variations. The ratio does not account for the impact of tax expenses. It is difficult to use this metric to compare companies across the spectrum as the ratio is variable for different industries.
