Interest coverage ratio measures the creditworthiness of a company by comparing earnings before interest and taxes (EBIT) with the interest. Its a financial ratio that measures company’s ability to make payments for debts. In other words, it gives a better picture to know the short-term financial health of a company.
Here is the formula to calculate the ratio:
Interest coverage ratio = EBIT / interest
Both figures can be obtained from company’s income statement. EBIT is the operating profit of a company.
This ratio can be helpful to following person as it determines the risk of lending funds;
- Investor looking for opportunity to invest in stocks
- Bank or lender assessing company on a potential loan
- Landlord looking for a long-term lease agreement
- Creditors extending credit facilities for purchase of goods or extending credit for a long term.
Analysis of interest coverage ratio
Interest coverage ratio is calculated to understand the profitability and the debt risk attached to it as it shows you the ability of the company to meet its debt obligations. You can also call it a solvency check. As a lender or creditor you can assess company’s further debt taking potential from it.
Higher ratio indicates that the company can more likely meet its obligations. If the ratio is 1 or less than 1, it means company is not making enough money to pay back its interest obligations. The company may have higher debt burden. This type of company is very risky to invest as they can be possibility of bankruptcy or default.
If the ratio is higher than 1, then company is making enough money to take care its periodic debt expenses. However, you need to look for other alternatives if the ratio is close to 1 and not more than 1.5. However, this ratio of 1.5 or 1 may change based on the type of industry that you invest in.
Company XYZ’s EBIT is Rs 5,00,000. Interest expenses for the period is Rs 2,50,000.
Company XYZ’s interest coverage ratio = Rs 5,00,000/2,50,000 = 2
Ratio of 2:1 indicates that the company’s earning is sufficient to pay its debt expenses.
However, as a investor you need to calculate its expected earnings to know whether the company can take care of its interest expenses in future.
You can measure the extent up to which EBIT can decline before the company is unable to meet its annual interest costs. You have to be very careful before investing in a high debt to asset company as failure to meet repayment of debts can bring legal action by the lenders and other creditors, possibly resulting in bankruptcy.