The interest coverage ratio is one of the most essential parameters to gauge a company’s capacity to pay off its debts. It is used by investors, lenders and creditors to evaluate the company’s financial health they have invested lent money to. Using the metric, they can know the borrowing firm's profitability and avoid any risk of default.
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The interest coverage ratio is a financial metric used to determine the number of times an organization can pay the interest due on its debts with its current earnings. It is calculated before applicable interest and taxes are deducted.
In other words, the interest coverage ratio helps know how easily a company can pay off the interest due on its debt. It is a debt-to-profitability ratio, sometimes called 'times interest earned'.
It is important to remember that the interest coverage ratio does not take into account the principal amount but only the interest accumulated on it.
Now that you know the interest coverage ratio, here’s how it is calculated.
The interest coverage ratio is computed by dividing a company's earnings before taxes and interest expenses by its interest obligations in the same period.
Here’s the formula to calculate the interest coverage ratio:
Interest coverage ratio = Earnings Before Taxes and Interest (EBIT)/ Interest expense
Interest coverage ratio = EBIT + Non-cash expenses/ Interest expense
The desirable interest coverage ratio can be different for every industry. However, the following points can help you analyze the metric better:
An interest coverage ratio of less than one suggests the borrowing firm is not generating enough profits to fulfill its interest obligations.
An interest coverage ratio below 1.5 reflects a high chance the borrowing firm may be unable to pay off interest on its debt obligations.
An interest coverage ratio between 2.5 and 3 indicates that the borrowing firm will easily pay off its interest obligations with available earnings.
The values mentioned above can vary from industry to industry. A ratio that is considered good for one industry may not be sufficient for another.
For example, sectors like natural gas, electricity, or other utility services usually have a low-interest coverage ratio. However, a high ratio is essential for industries like manufacturing, technology, consumer goods, etc.
The interest coverage ratio is an essential metric for the following reasons:
The interest coverage ratio can have the following limitations:
The interest coverage ratio is a valuable metric for lenders and investors who wish to invest in a company. A low ratio indicates that the company is burdened by its debt obligations. It also indicates a greater possibility of bankruptcy or default, which hurts the company’s goodwill.
However, the interest coverage ratio is not the sole criterion to gauge a firm’s financial standing. It should be used with other metrics like cash ratio, current ratio, debt-to-equity ratio, etc., to make a more informed decision.