Interest coverage ratio is the debt and profitability ratio used to determine how easy a company can pay interest on its outstanding debt. Interest coverage ratio can be calculated by dividing the company's earnings before interest and taxes (EBIT) over a certain time for interest payments made by the company maturing in the same period.
The interest coverage ratio is also called the interest earned. Lenders, investors, and creditors often use this formula to determine a company's risk concerning current or future loans.
Key Factor
- Interest coverage ratio is used to see how well a company can pay interest on its outstanding debt.
- Also known as the time-interest-earned ratio, this ratio is used by potential creditors and lenders to assess the risk of a loan to a company.
- Higher coverage ratio is better, although the ideal ratio may vary by industry.
The formula for calculating interest coverage ratio
Interest Coverage Ratio= EBIT/Interest Expense
EBIT = Earnings before interest and taxes
Understand the interest coverage ratio
Interest coverage ratio measures the number of times the company can pay its current interest payments on disposable income. In other words, it measures a company's safety to pay interest on its debt over a specified time. Interest coverage ratio is used to determine how easy a company can pay interest expenses on outstanding debt.
The ratio is calculated by dividing the company's earnings before interest and taxes (EBIT) by the company's interest expenses over the same period. The lower this ratio, the more the company incurs debt burden. When the interest coverage ratio of a company is only 1.5 or lower, a company's ability to meet interest expenses may be questionable.
Companies need to have enough income to pay for the money they may generate. A company that is capable of fulfilling its interest obligations is an aspect of solvency and therefore a very important factor in the shareholders' profits.
Although looking at an interest ratio may show a good deal on the company's current financial situation, analyzing interest coverage ratio over time will often give a clear picture. More clear about the situation of the company.
For example, by analyzing the interest coverage ratio quarterly for the past five years, trends can appear and give investors a much better idea of whether interest ratio is low. improving or worsening, or if the current interest coverage ratio is stable. Ratios can also be used to compare the interest ratio of different companies, which can be useful when making investment decisions.
In general, stability in interest coverage ratio is one of the most important things to look for when analyzing interest coverage ratio in this way. Decreasing interest coverage ratio is often a precaution for investors, as it shows that a company may not be able to pay its future debts.
Finally, the interest coverage ratio is an effective assessment of a company's short-term financial ability. Although making future predictions by analyzing the history of interest coverage ratio of the company may be a good way to assess investment opportunities, it is still difficult to accurately predict the strength. The company's long-term financial health at any ratio or metric.
Trends over time
interest coverage ratio at a time may help analysts know a little about the company's ability to handle debt, but analyzing interest coverage ratio over time will provide a clear picture. more about whether their debt becomes a burden for the company. Decreasing interest coverage ratio is something that makes investors wary, as it shows that a company may not be able to pay its future debts.
However, it is difficult to accurately predict a company's financial situation by any percentage or figure. Besides, each person's expectations for this ratio are also different. Some banks or potential bond buyers may be comfortable with less desirable rates in exchange for giving the company a higher interest coverage ratio on their debt.
Example of Use of Interest Coverage Ratio
To provide an example of how to calculate interest coverage ratio, suppose that a company's income for a given quarter is $ 650,000 and they have $40,000 in liabilities.
To calculate the interest coverage ratio here, one will need to convert monthly interest payments into quarterly payments by multiplying them by three. The interest coverage ratio for the company is $ 650,000/($40,000 x 3) = $ 650,000/$120,000 = 5,42.
The lower the interest coverage ratio is, the more debt expenses the company will burden the company. When the interest coverage ratio of a company is 1.5 or lower, a company's ability to meet its interest expenses may be questionable.
The result of 1.5 is often considered the acceptable minimum ratio for a company and the tipping point below is that lenders may refuse to lend the company more money, because of the risk. The company may be considered too high.
Furthermore, interest coverage ratio of less than 1 suggest that the company does not generate enough revenue to cover interest expenses. If the company's ratio is below 1, it may be necessary to spend part of its cash reserves to meet the spread or borrow more, which will be difficult for the reasons stated above. On the other hand, even if the income is low for a month, the company is in danger of going into bankruptcy
Although it generates debt and interest, borrowing has the potential to positively affect a company's profitability through capital asset development based on cost-benefit analysis. But a company must also be smart in borrowing. Because interest also affects a company's profitability, a company should only borrow if it knows it will handle interest payments well for many years to come.
A good interest coverage ratio will act as a good indicator of this situation and is likely to be an indicator of the company's ability to repay its debt. However, large corporations can often have both high-interest rates and very large loans. With the ability to pay large interest payments regularly, large companies can continue borrowing without much worry.
Businesses can usually survive for a very long time while paying off interest and not debt. However, this is often considered a risky practice, since it is usually a small company and therefore has lower revenue than larger companies.
Limitation of interest coverage ratio
Like any business performance measurement, interest coverage ratio has a range of restrictions that any investor needs to consider before using it.
It is important to note that interest insurance is very different when measuring companies in different industries and even when measuring companies in the same industry. For companies established in some industries, such as a utility company, an interest coverage ratio of 2 is usually an acceptable standard.
Although this is a low number, a well-established utility will be capable of producing very consistent sales and revenue, especially due to government regulations, so even with interest coverage ratio. Relatively low interest coverage ratio, it can reliably afford. Other industries, such as manufacturing, are volatile and often have higher acceptable minimum interest coverage ratio, such as 3.
These types of companies generally see greater volatility in their business. For example, during the 2008 recession, car sales dropped significantly, damaging the automobile industry. A worker strike is another example of an unexpected event that could hurt interest coverage ratio. Because these industries are susceptible to these fluctuations, they must rely on their greater ability to cover their interests to account for low-income periods.
Due to wide variations like this, when comparing companies, interest rates, certainly only compare companies in the same industry and ideally when companies also have business models and Similar revenue numbers.
The fluctuation of interest coverage ratio
A few common variations of interest coverage ratio is important to consider before researching the ratio of companies. These variations come from changes to EBIT.
Such a variation uses interest income, taxes, depreciation, and amortization (EBITDA). Because this variation does not include depreciation and amortization, the numerator in the calculation using EBITDA will usually be higher than the variation using EBITDA. Because interest expenses will be the same in both cases, calculations that use EBITDA will generate a higher interest coverage ratio than calculations using EBIT.
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