Interest Coverage Ratio
What Is the Interest Coverage Ratio?
The interest coverage ratio is a financial metric that measures a company’s ability to make interest payments on its debt.
The interest coverage ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expenses.
A high interest coverage ratio indicates that a company has significant earnings relative to its interest expenses, meaning it should have no problem making interest payments on its debt.
A low interest coverage ratio indicates that a company has weak earnings relative to its interest expenses, which could lead to difficulty making interest payments.
Interest coverage ratios can be used to assess the financial health of a company as well as the riskiness of its debt.
A company with a strong interest coverage ratio is generally considered to be in good financial health, while a company with a weak interest coverage ratio may be at risk of defaulting on its debt.
Investors and creditors often use the interest coverage ratio to assess the risks associated with lending money to a company.
A high interest coverage ratio indicates that a company is less likely to default on its debt, while a low interest coverage ratio indicates that a company is more likely to default.
The interest coverage ratio is just one metric that can be used to assess a company’s financial health.
Other important measures include the debt-to-equity ratio, the return on equity (ROE), asset turnover, and cash flow ratios.
How to Calculate the Interest Coverage Ratio (Interest Coverage Ratio Formula)
The interest coverage ratio formula is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expenses.
EBIT can be found on a company’s income statement, while interest expenses can be found on a company’s balance sheet.
The interest coverage ratio formula is as follows:
Interest Coverage Ratio = EBIT / Interest Expenses
Types of Interest Coverage Ratios
While the interest coverage ratio often uses EBIT, there are often other financial metrics used instead.
EBITDA
The EBITDA interest coverage ratio is calculated by dividing a company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) by its interest expenses.
Operating cash flow
The operating cash flow interest coverage ratio is calculated by dividing a company’s operating cash flow by its interest expenses.
Free cash flow
The free cash flow interest coverage ratio is calculated by dividing a company’s free cash flow by its interest expenses.
EBIAT
The EBIAT interest coverage ratio is calculated by dividing a company’s earnings before interest and after-taxes (EBIAT) by its interest expenses.
Earnings (Net Income)
The earnings interest coverage ratio is calculated by dividing a company’s net income by its interest expenses.
Interest coverage ratio explained
Advantages and Disadvantages of the Interest Coverage Ratio
The interest coverage ratio has several advantages and disadvantages that should be considered when using this metric.
Advantages
- Simple to calculate and understand
- Can be used to assess the financial health of a company
- Can be used to help determine the riskiness of a company’s debt
Disadvantages
- Does not take into account all interest payments (only interest expense)
- Does not take into account the timing of interest payments
- May not be accurate for companies with high levels of debt where overall debt service is more important
Why the Interest Coverage Ratio Is Important
The interest coverage ratio is a key indicator of a company’s financial health.
It is used to measure a company’s ability to pay its interest expenses on its outstanding debt.
A high interest coverage ratio indicates that a company has a strong ability to service its debt, while a low interest coverage ratio indicates that a company may have difficulty in meeting its interest payments.
The interest coverage ratio is important for both lenders and investors.
Lenders use the ratio to assess a company’s creditworthiness, and investors use the ratio to evaluate how healthy a company might be.
For lenders, a high interest coverage ratio indicates that a company is less likely to default on its debt payments.
For investors, a high interest coverage ratio indicates that a company’s profits and cash flow won’t be materially impacted by its interest payments.
Interest Coverage Ratio Example
For example, let’s say that Company XYZ has an EBIT of $1 million and interest expenses of $500,000.
This would give Company XYZ an interest coverage ratio of 2 ($1 million/$500,000).
This means that for every $1 in interest expense, Company XYZ has $2 in earnings.
This is a strong interest coverage ratio, and it indicates that Company XYZ should have no trouble making its interest payments.
How to Improve the Interest Coverage Ratio
There are a few ways to improve the interest coverage ratio:
Reduce interest expenses
One way to reduce interest expense is to refinance debt at a lower interest rate.
Another way to reduce interest expenses is to pay off high-interest debt.
Increase earnings
To increase earnings, a company will need to increase revenue and/or reduce its expenses.
Decrease debt
One way to decrease debt is to sell assets and use the proceeds to pay down debt. It can also decrease debt by using cash flow from operations to pay it down.
Interest Coverage Ratio Limitations
The interest coverage ratio has a few limitations that should be considered when using this metric.
First, the interest coverage ratio only takes into account interest expenses, and it does not into account the overall debt load (interest plus principal).
Second, the interest ratio does not take into account the timing of interest payments. For example, a company have a high interest coverage ratio but it may still struggle to make its interest payments if those payments are due in the short term.
Third, the interest coverage ratio may not be accurate for companies with high levels of debt.
This is because a company with high levels of debt may have difficulty refinancing its debt at a lower interest rate, and it may also have difficulty paying off its debt in full.
Despite these limitations, the interest coverage ratio is still a valuable metric for assessing a company’s financial health.
It should be used in conjunction with other financial ratios and indicators to get a complete picture of a company’s financial condition.
What Is a Good Interest Coverage Ratio?
There is no hard and fast rule for what is a good interest coverage ratio.
However, a general guideline is that an interest coverage ratio of 2 or higher is considered strong, while an interest coverage ratio of 1 or lower is considered weak.
A interest coverage ratio below 1 means that a company is not generating enough EBIT or operating income to cover its interest payments, which could lead to financial difficulties now or in the future.
Interest Coverage Ratio – FAQs
Why Is the Interest Coverage Ratio Important?
The interest coverage ratio is an important financial metric because it measures a company’s ability to make interest payments on its debt.
A high interest coverage ratio indicates that a company is less likely to default on its debt payments.
A low interest coverage ratio indicates that a company may have difficulty making its interest payments, which could eventually lead to financial difficulties.
What Is a Good Interest Coverage Ratio?
There is no hard and fast rule for what is a good interest coverage ratio.
However, a general guideline is that an interest coverage ratio of 2 or higher is considered strong, while an interest coverage ratio of 1 or lower is considered weak. Something between 1 and 2 would be considered somewhere in between.
What Are the Limitations of the Interest Coverage Ratio?
When using the interest coverage ratio to assess a company’s financial health, it is important to be aware of its limitations.
One such limitation is that the ratio does not take into account the timing of interest payments.
For example, a company may have strong interest coverage in one year but make most of its interest payments early in the year, when its cash flow is low.
As a result, the company may have difficulty making its interest payments in subsequent years.
Another limitation of the interest coverage ratio is that it does not take into account the possibility of default.
Even if a company has strong interest coverage, it may still default on its debt if it is unable to make its principal payments.
Finally, the interest coverage ratio does not take into account the riskiness of a company’s debt.
For example, a company may have strong interest coverage but its debt may be high-yield junk bonds that are at a greater risk of default.
Investors should keep these limitations in mind when using the interest coverage ratio to assess a company’s financial health.
How Is the Interest Coverage Ratio Calculated?
The interest coverage ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expenses.
For example, if a company has an EBIT of $1,000 and interest expenses of $500, its interest coverage ratio would be 2 ($1,000/$500).
What Is the Difference Between the Interest Coverage Ratio and the Debt-to-Equity Ratio?
The interest coverage ratio measures a company’s ability to make interest payments on its debt.
The debt-to-equity ratio measures the amount of debt a company has compared to the amount of equity.
The interest coverage ratio is a more specific metric that is used to assess a company’s financial health, while the debt-to-equity ratio is a broader metric that is used to assess a company’s overall financial leverage.
What Is the Difference Between the Interest Coverage Ratio and the Debt Service Coverage Ratio?
The interest coverage ratio measures a company’s ability to make interest payments on its debt.
The debt service coverage ratio (DSCR) measures a company’s ability to make all of its debt payments, including interest, principal, and lease payments.
The interest coverage ratio is a more specific metric that only looks at interest payments, while the DSCR is a broader metric that looks at all debt payments.
What Is the Difference Between the Interest Coverage Ratio and the Debt-to-Income Ratio?
The interest coverage ratio measures a company’s ability to make interest payments on its debt.
The debt-to-income ratio (DTI) measures an individual’s monthly debt payments compared to their monthly income.
The interest coverage ratio is a corporate financial metric, while the DTI is mostly an individual financial metric.
How Do I Interpret the Interest Coverage Ratio?
An interest coverage ratio of 2 or higher is considered strong, while an interest coverage ratio of 1 or lower is considered weak.
However, it is important to remember that the interest coverage ratio is just one metric, and it should be used in conjunction with other financial ratios and indicators to get a complete picture of a company’s financial condition.
A high interest coverage ratio indicates that a company is able to easily make interest payments on its debt.
A low interest coverage ratio indicates that a company may struggle to make interest payments on its debt.
Summary – Interest Coverage Ratio
The interest coverage ratio is a key financial metric that should be monitored by both lenders and investors.
A high interest coverage ratio indicates that a company has a strong ability to service its debt, while a low interest coverage ratio indicates that a company may have a hard time meeting its interest payments.
There are a few ways to improve the interest coverage ratio, such as reducing interest expenses, increasing earnings, or decreasing debt.
It is important to remember that the interest coverage ratio is just one metric, and it should be used in conjunction with other financial ratios and indicators to get a complete picture of a company’s financial condition.