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What is Interest Coverage Ratio; Everything You Need to Know

10 Mins 29 May 2023 0 COMMENT

While investing in a company, it is imperative that you take steps to gauge the financial health and position of the same. Doing so is important because it could affect how your investments pan out and the kind of returns you might end up earning. One such parameter is to have an idea of the capability of a company to repay its debts. Thankfully, you can rely on various metrics to help you get a grasp of a company’s finances. As far as debt repayment capacity is concerned, the interest coverage ratio is a metric that comes in handy. Continue reading to learn more about what interest coverage ratio means, how to calculate the same, and how it can be a useful tool.

What is Interest Coverage Ratio?

The interest coverage ratio is an accounting ratio instrumental in helping you determine how many times a company can pay off any accumulated interest prior to interest and taxes being subtracted. It is also commonly known as the ‘times interest earned’. Do note that this ratio only takes the interest payment into consideration and does not include the repayment of the principal amount.

Here, the term ‘coverage’ also refers to the number of times, usually in terms of quarters or fiscal years. Thus, the interest coverage ratio measures the number of times a company can use its existing earnings to pay accumulated interest payments.

How to Calculate Interest Coverage Ratio?

Like most metrics, you can also calculate the interest coverage ratio manually, by using the formula given below:

Interest Coverage Ratio = EBIT / Interest Expense

Here, EBIT refers to Earnings Before Interest and Taxes. It is the operating profit of the company. The interest expense includes all the interest paid on liabilities and borrowings such as loans, bonds, etc.

To calculate the interest coverage ratio, all you need to do is divide the earnings generated by a firm, prior to the interest and taxes are paid, by the interest expenses for the same time period.

While you can use this formula to undertake manual calculations, an easier option would be to use an interest coverage ratio calculator. It is an online tool wherein you can plug in the pertinent details and the results will be displayed to you instantly. An online interest ratio coverage calculator would help you save the time taken by manual calculations and also provide accurate results.

How to Interpret Interest Coverage Ratio?

Once you have determined a company’s interest coverage ratio, whether by using the manual formula or an online calculator, you can use the guide given below to understand what the figure indicates:

High Interest Coverage Ratio:

If you end up with a result that shows a high interest coverage ratio, it indicates that the company is capable of using its earnings to pay its debts. This means that the company can keep revenues stable. Generally, a ratio of 1.5 would be considered better. If the company you are considering has had a history of unpredictable revenues, then an interest coverage ratio above three would be regarded as favourable.

Lower Interest Coverage Ratio:

Any value below one means that the company does not have enough revenue to pay off its existing debt. If the interest coverage ratio is less than 1.5 then the company’s condition appears better, but its ability to pay off its interest payments on a consistent basis is doubtful. This is especially so if the company experiences seasonal or cyclical revenue fluctuations. However, an ideal interest coverage ratio may vary by sector or industry.

What is the Importance of Interest Coverage Ratio?

Now that you know what the interest coverage ratio is and how it is calculated, it is vital to understand why it is an important metric:

Helps Companies Manage Repayment:

Keeping a check on the interest coverage ratio can help a company understand where it stands regarding debt repayment capabilities. If required, a company can make modifications to generate a revenue stream that will help with the interest payments.

Guides Investors:

The interest coverage ratio is an indicator that can go a long way in helping investors gauge a company’s financial position. Additionally, if considered over time, it can also showcase the position of the company and the likely direction in which it would be heading.

Overall, the benefits of using an interest coverage ratio are as follows:

  • It helps investors make informed decisions regarding the profitability of a company.
  • It helps companies utilise their funds so as it pay off their debt without having to rely on borrowed funds for the same.
  • Creditors or lenders can utilise this ratio to evaluate the creditworthiness of the company before lending.

Do note that despite its many advantages, the interest coverage ratio is subject to certain limitations. Firstly, it can differ as per industry. Second, a matured company might have a low-interest coverage ratio and still manage its interest payments. It also does not factor in companies excluding certain types of debt from the calculations.

Investors may use the interest coverage ratio as a tool to evaluate a company's financial health and ability to repay debt. However, it is important to consider the advantages and limitations of this ratio and to conduct research before making an investment decision.

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