Interest Coverage Ratio

5paisa Research Team

Last Updated: 13 Dec, 2022 05:57 PM IST

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Interest Coverage Ratio

An interest coverage ratio is a crucial tool for determining if a company's revenues are sufficient to cover the interest on its loan obligations when it comes to risk management because it allows an organization to assess its solvency. It allows companies, investors, and analysts to quickly determine if a company is now able to pay down accrued interest on the debt.

What Is Interest Coverage Ratio?

The interest coverage ratio is a debt and profitability statistic that measures how a corporation can pay interest on existing debt. To attain the interest coverage ratio, divide a company's earnings before interest and taxes (EBIT) by its interest expenditure over a specific period. The times interest earned (TIE) ratio is another name for the interest coverage ratio. This method is frequently used by lenders, investors, and creditors to assess a company's riskiness to its present debt or for future borrowing.

Understanding the Interest Coverage Ratio

In the interest coverage ratio meaning, the phrase "coverage" refers to the number of times or instances, generally indicating quarters or fiscal years. It is the number of instances in which the company's existing earnings are used to make interest payments. It reflects how many times the company's revenues may be used to satisfy its commitments.

As per the Interest Coverage Ratio formula, there can be either a High-Interest Coverage Ratio or a Low-Interest Coverage Ratio, which is explained below:

●    High-Interest Coverage Ratio: A ratio larger than one indicates that a company's earnings can cover its obligations. The firm can maintain consistent revenue. Furthermore, a ratio of 1.5 might be regarded as enough. Analysts and investors often favour two or higher. It may not be considered advantageous for firms with historically more volatile sales until it is far higher than three.

●    Low-Interest Coverage Ratio: Any number less than one signifies a negative interest coverage ratio. This suggests that the company's current revenues are insufficient to pay down its existing debt. If it is less than 1.5, it indicates that the company's ability to meet its interest expenditures continuously is still in doubt. It's debatable, especially if the company's revenue is subject to seasonal or cyclical swings, and that affects the overall performance.

Companies must generate more than enough to cover interest payments to endure future, maybe unanticipated, financial difficulties. The capacity of a company to satisfy its interest commitments is a facet of its solvency and hence a significant determinant in shareholder return.

Importance of the Interest Coverage Ratio

The importance of the Interest Coverage Ratio is explained below:

●    Many businesses confront the issue of consistently servicing interest liabilities. Keeping up with interest payments is an important and continuous worry for every business. Solvency and liquidity must have an income stream to cover these liabilities. When a corporation is unable to meet its obligations, it may be obliged to borrow additional funds or use its cash reserve. Such funds would be better spent on capital assets or meeting contingencies.

●    A single interest coverage ratio might reveal a great deal about a company's present financial status. However, looking at it over time might show a company's position and direction.

●    It is recommended to examine the company's interest coverage ratios regularly during the last several years. An examination of the ratio across several fiscal years would reveal whether it is improving, declining, or stable. It also indicates the company's short-term financial health.

●    Additionally, the acceptance of any particular level of this ratio, to some extent, depends on the company analyst. Some banks, investors, and lenders may be ready to accept a lower ratio in return for a higher loan interest rate.

Interest Coverage Ratio Example

Assume a company's profits for a given quarter are \$500,000, and it has obligations that need monthly payments of \$30,000 To compute the interest coverage ratio in this case, multiply the monthly interest payments by three to convert them to quarterly payments. The company's interest coverage ratio calculation will be \$500,000 / \$90,000 (\$30,000 x 3) = 5.55. This means that the firm currently has no liquidity issues.

As per the interest coverage ratio definition, if the company’s interest coverage ratio is 1.5, it is considered a minimum acceptable ratio for a firm, and the tipping point below which lenders would likely refuse to lend the company additional money since the company's risk of default is judged to be too significant.

If a company's ratio is less than one, it will most likely need to consume a portion of its cash reserves or borrow more to make up the gap, which will be problematic for the reasons described above. Therefore, even if earnings are poor for a single month, the firm risks going bankrupt.

Types of Interest Coverage Ratios

Before considering the company’s interest coverage ratio, it is crucial to know two rather typical versions of the interest coverage ratio. These variances result from changes to EBIT.

EBIT stands for Earnings Before Interest and Taxes. Earnings Before Interest and Taxes (EBIT) is the organization's operational revenue, which includes sales revenue and operating expenditures. There are two methods for computing EBIT.

One method is to add the interest obligations and taxes payable to the net operating income. Because interest and taxes were deducted in the first instance, they are put back in. The second method is simply to look at the operating income line item on the profit and loss statement.

EBIT = Revenue minus Cost of Goods Sold minus Operating Expenses.

1.    Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA): Instead of EBIT, one form of the interest coverage ratio (EBITDA) uses earnings before interest, taxes, depreciation, and amortization. Depreciation and amortization are not included in EBITDA; it is frequently worth more than EBIT. Because interest expenditure is the same in both cases, EBITDA calculations provide a larger interest coverage ratio than EBIT calculations.

2.    EBIAT stands for Earnings Before Interest and After Taxes: Earnings before interest and taxes (EBIAT) rather than EBIT are used in the interest coverage ratio. EBIAT necessitates deducting tax obligations from the numerator. As a result, the EBIAT method provides a better representation of a company's capacity to pay interest charges.

Tax obligations are both required and compulsory. Because of their tax structure, many corporations' tax liabilities are relatively large. It, therefore, appears appropriate to deduct it. EBIAT, rather than EBIT, can be utilized to calculate interest coverage ratios using this method. EBIAT, like EBITDA, offers a more accurate picture of a company's ability to cover its interest expenses.

Limitations of the Interest Coverage Ratio

While this is an excellent ratio, it does have some limitations. It may change depending on the industry, and various ratios may be acceptable in other industries. Furthermore, while comparing firms, organizations in the same industry should be picked over companies from other industries, conditions, or business strategies.

A matured corporation will have consistent output and income due to government regulations. As a result, even with a low-interest coverage ratio, it may be able to cover its interest payments constantly. If interest expenditure is incurred throughout the time, the ratio may show a default. However, such an interest expense is not owed. This debt default will not happen until the interest is due.

How Is the Interest Coverage Ratio Calculated?

The ratio is computed by dividing EBIT (or any variation thereon) by interest on debt costs (the cost of money borrowed) over a specific time, generally a year.

The Interest Coverage Ratio formula is as follows:
Interest Coverage Ratio = EBIT / Interest Expense

Conclusion

Individuals looking to invest should utilize the interest coverage ratio, along with other metrics such as the quick ratio, current ratio, and cash ratio, to analyze a firm's financial statements. It will assist in maximizing the benefits of the measure and more effectively buffer the deficiencies. Additionally, before investing in or lending funds to a specific company, one should consider other aspects.