Interest coverage ratio
Formula for the interest coverage ratio
You can calculate interest coverage ratios using this formula:
Interest coverage ratio = EBIT ÷ interest expense
EBIT, also referred to as operating profit or operating income, stands for “earnings before interest and taxes.” The company’s interest expense is the amount of interest it paid on its debts during a specific time frame.
Since EBIT is a more accurate indicator of how much money a company has available to pay interest, it is used in the interest coverage ratio rather than net income. If you used a company’s net income to calculate its interest coverage ratio, you would double-count its interest expenses because net income is what’s left over after taxes and accrued interest are subtracted from earnings.
Variations of the interest coverage ratio
Using metrics other than EBIT to calculate interest coverage ratio can give insight into a company’s financial health. Some beneficial adaptations of the interest coverage ratio use:
Because taxes, along with interest, eat up a sizable portion of a company’s earnings, EBIT does not account for taxes, which is one of the standard income coverage ratio’s biggest flaws. Since taxes have already been deducted from EBIAT, the interest coverage ratio it produces may more accurately reflect a company’s capacity to pay its interest. Because it assumes the company will pay the full tax rate, many analysts believe EBIAT to be an overly conservative measure of a company’s earnings. In reality, many companies gain tax benefits from debt financing.
Using EBITDA instead of EBIT results in a higher interest coverage ratio and, consequently, a more forgiving assessment of a company’s ability to pay interest expenses because EBITDA is not adjusted for depreciation and amortization. Companies with low capital expenditures (and therefore fewer assets depreciating) may be able to calculate the interest coverage ratio using EBITDA.
What is the interest coverage ratio?
A liquidity ratio called the interest coverage ratio compares a company’s earnings over a period (before deducting interest and taxes) with the interest due on its debts as of the same period. The interest coverage ratio of a company measures its capacity to cover interest expenses from available profits. Because of this, lenders and investors can evaluate a company’s financial health using its interest coverage ratio.
A higher interest coverage ratio may indicate that a company can afford its debt comfortably while a lower interest coverage ratio may indicate that a company is struggling to pay its interest. Higher interest coverage ratios make it easier for businesses to get loans because they show lenders that they can afford higher interest costs. Similarly, a business is more likely to draw investors if it has a higher interest coverage ratio because it denotes that the business is profitable and financially stable, making it an investment with a lower risk.
The number of times a company could pay its interest expenses using its available earnings is another way to think about a company’s interest coverage ratio. For instance, a business with a ratio of interest coverage of two could theoretically pay its interest costs twice. The interest coverage ratio is also referred to as “times interest earned” because of this. “.
How to calculate the interest coverage ratio
You must first determine a company’s EBIT and interest expenses in order to calculate its interest coverage ratio. The most recent income statement of the business, which publicly traded companies are required to submit to the U S. Securities and Exchange Commission as part of their annual reports. You can access this information through EDGAR, the U. S. Securities and Exchange Commissions online database. Remember that on an income statement, EBIT is frequently referred to as operating profit or operating income.
Simply enter the company’s EBIT and interest expenses into the formula provided in the previous section once you have located them.
Example of the interest coverage ratio
Looking for a company’s EBIT and interest expenses in its income statement can be confusing when attempting to calculate its interest coverage ratio. The remainder of this section calculates the hypothetical company’s interest coverage ratio using an example income statement to make the process more understandable.
The first nine lines of Findman Wholesale Corp. s income statement reads:
Net sales of $10 million; cost of sales of $6,990,000; selling, general, and administrative expenses of $1 million; pre-opening expense of $10,000; operating income of $2 million; interest expense, net; income before income taxes of $1 million; and provisions for income taxes of $40,000; net income of $960,000.
The operating income (EBIT) is $2,000,000 and the interest expense is $1,000,000 according to the income statement. Therefore, Findman Wholesale Corp. s interest coverage ratio is $2,000,000 ÷ $1,000,000 = 2.
Analyzing the interest coverage ratio
Interest payments place an especially large strain on a company’s finances if it has a low interest coverage ratio. A risky investment for lenders and investors, such a company may be more likely to miss payments or file for bankruptcy.
A company cannot afford to cover its interest expenses from operating income if its interest coverage ratio is less than 1. If a company has an interest coverage ratio of 1, it means that it must devote all of its operating income to interest payments in order to meet its obligations. This means that there is no money left over after depreciation, principal payments, or other expenses to offset. A company is losing money in either scenario, and it is almost certain that it will not be able to obtain additional loans or investments.
Lenders typically look for an interest coverage ratio of 1 as the absolute minimum. 5 before agreeing to loan a company more money. However, most lenders expect interest coverage ratios higher than 1. 5 (between 2 and 3 is a common requirement).
There isn’t a set standard for what constitutes an acceptable interest coverage ratio; some lenders are just more risk-averse than others. The same is true of investors. Before purchasing stock, most investors want some proof that a company will expand and produce a profit. Although a lower interest coverage ratio indicates that a company’s debt load is too heavy to hinder its growth, some investors might be willing to make higher-risk investments if they believe that the interest coverage ratio is an unfair indicator of a company’s long-term viability.
Deterioration of the interest coverage ratio
An indication that a company’s earnings are declining relative to its debt may be a declining interest coverage ratio. Even if a company’s current ratio is still higher than the minimum that most new lenders and investors would be comfortable with, it may eventually become unstable financially if its interest coverage ratio has consistently declined over several periods. Therefore, both current shareholders and potential investors may view a declining interest coverage ratio as a serious warning sign.
There are numerous factors that can cause a company’s interest coverage ratio to decline. When a business has high operating leverage (high fixed costs compared to variable costs), its operating income will decline, which will worsen its interest coverage ratio. Another culprit might be increased interest rates. A declining interest coverage ratio is cause for concern if it lasts for an extended period of time, regardless of the cause.
Additional considerations when analyzing interest coverage ratio
The interest coverage ratio alone, like any other financial ratio, does not provide a full picture of a company’s financial situation. In addition to interest coverage ratio, it is crucial to take the following factors into account when evaluating a company:
A company’s ability to pay its interest expenses is more accurately reflected by trends in interest coverage ratio than by a single data point. For instance, a business seeking to expand might obtain financing to build a new facility. Even though the income statement includes the higher interest expenses from the most recent loan, the facility the loan financed may significantly increase operating income in the future, so the company’s interest coverage ratio may be low when calculated using the figures on its upcoming income statement.
Conversely, lenders are more likely to reject a company with the same interest coverage ratio if its profits are erratic than they are to lend to one with a lower interest coverage ratio if its profits are extremely stable. If a company has an interest coverage ratio of 1. Lenders still have reason to believe the business will be able to take on more debt because it has a 5 or 2 but has consistently produced operating income for a long time. Investors can also have more faith that the company’s debt won’t impede its expansion.
Expectations for a company’s interest coverage ratio can differ across industries because some generate more consistent profits than others by nature. Companies in vital sectors like utilities can afford a lower interest coverage ratio because the demand for electricity and water is generally steady, making it easier for established utility companies to manage their debts. To reassure lenders and investors, businesses in more volatile industries may require higher interest coverage ratios. The interest coverage ratio is most useful when contrasting businesses in the same industry because of these variations.