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Interest Coverage Ratio: Definition, Formula & Explanation

Sarmaaya Desk
Sarmaaya Content Team

Key Takeaways:

  1. The interest coverage ratio is also known times interest earned
  2. It determines how easily can a company pay its interests on its outstanding share
  3. Higher the interest coverage ratio, stronger will be the company’s financial health
  4. It measures a margin of safety for the company in paying interest on the debt for a given period
  5. It is important to see trend in ratio over a period of time to understand a company’s financial position better.

What is Interest Cover Ratio

The interest coverage ratio is also known times interest earned and is a ratio between debt and profitability. It determines how easily can a company pay its interests on its outstanding share. Investors and analysts use this ratio to determine how risky investing in the company is either for current debt or future borrowing.

How to calculate it?

We calculate the interest coverage ratio by dividing a company’s EBIT (earnings before interest and taxes) with the interest expense over a period of time when payments are due. The formula used for calculation is as follows:

Interest Cover Ratio = EBIT / Interest Expense

For Example, Ali co.’s earnings before interest and taxes are $100,000 and its interest payment is $ 100,000 then the interest coverage ratio is equal to equal to 1.

This indicates that Ali co. is at high risk since it’s only able to cover its interest payments rather than lowering the burden of its debts.

Higher the interest coverage ratio, stronger will be the company’s financial health. Usually, if the interest coverage ratio is lower than 1.5 then it’s a warning sign as the investors are reluctant to offer additional funds due to risk of default.

Understanding Interest Cover Ratio

The interest coverage ratio measures the number of times a company can make its interest payments with the earnings it already has. In other words, the ratio measures a margin of safety for the company in paying interest on the debt for a given period.

A lower ratio indicates that the company has more debt expense than optimal and its ability to meet interest expenses are severely questionable. As mentioned before, the ratio should not be lower than 1.5, otherwise, it would be a cause for worry.

It is preferred for the companies to have enough earnings to cover payments that can help them survive unforeseeable financial difficulties of the future. To be able to meet their interest obligations shows the company’s solvency – thereby indicating importance for the shareholders.

Simply looking at a ratio will not give you desired analytical results. Looking at a single ratio will help investors and analysts understand a company’s current financial position. However, if they look at the trend over a period of time, they will be able to gauge a complete overview of the company’s standing and where it is headed. A declining ratio, for example, will let the investors know to be careful because the company may not be able to pay its debt in future.

 




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