What is the Interest Coverage Ratio?
If you’ve read our ‘Quick Guide to Financial Ratios’ you’d be aware of what debt and profitability ratios are. The interest coverage ratio is used in determining the ease with which a company can pay interest on its outstanding debt. It classifies as a type of debt and profitability ratio. It is also sometimes referred to as “times interest earned”. Creditors, lenders, as well as investors, use it to determine how risky investing in the company might prove to be given its current debts.
How is it calculated?
This ratio is calculated by dividing the company’s EBIT (Earnings Before Interest and Taxes) by the company’s interest payments in a given period of time.
Interest Coverage Ratio = EBIT / Interest Expense
How can you use Interest Coverage Ratio to your benefit?
I’ll try to explain this to you vide an example.
Consider a company ‘A’ which clocks revenue of Rs. 10,00,000/- every quarter. Suppose its debt payments to be around Rs. 30,000/- every month. Its interest coverage ratio can be calculated as Rs. 10,00,000 / (Rs. 30,000 * 3) = Rs. Rs. 10,00,000 / (Rs. 90,000) = 11.11.
Similarly, consider a company ‘B’ which clocks revenue of Rs. 1,00,000/- every quarter. Suppose its debt payments is the same as in the case of ‘A’, around Rs. 30,000/- every month. Its interest coverage ratio can be calculated as Rs. 1,00,000 / (Rs. 30,000 * 3) = Rs. Rs. 1,00,000 / (Rs. 90,000) = 1.11.
Paying off interest on the debt is a regular affair for every company. Thus, if logically analyzed, the lower a company’s interest coverage ratio, the more questionable its ability to meet this expense. This range is usually capped at 1.5, i.e. a company clocking interest coverage ratio to be 1.5 or lower is risky to invest in. In most cases, companies such as these may see the need to dip further into its cash reserve to pay the debt off.
In this example, company ‘A’ clocks a ratio of 11.11, rendering it as a rather safe investment with regards to its interest coverage ratio. However, company ‘B’ has a ratio of 1.11, which falls below the acceptable 1.5 caps, thereby making it a risky investment.
In most cases, companies that have an interest coverage ratio below highlights their inability to generate sufficient revenue overall. Considering that it may need to dig into its cash reserves to meet the going expense, it has a high risk of falling into bankruptcy.
A good interest coverage ratio serves as a sound indicator of the company’s ability to pay its debt off. Along with other parameters, adding Interest Coverage Ratio as a fundamental parameter on which to base investment decisions is highly advisable.
I hope this article helped you learn about what Interest Coverage Ratio is, and how you can use it to make a sound investment decision.