What’s it: The interest coverage ratio is a financial ratio to measure a company’s ability to pay interest expense using the profit it generates. Earnings before interest and tax (EBIT) is a commonly used profit metric. It is then divided by interest expense.
The ratio shows how many times EBIT can cover interest expenses. Because EBIT is a proxy for the money a company makes during the accounting period, the interest coverage ratio provides insight into how easily a company can pay interest.
A higher ratio is generally preferred because the company has a better ability to pay interest. However, the ideal ratio may vary between companies, depending on which industry they operate.
Why is the interest coverage ratio important?
Analysts use the interest coverage ratio to evaluate a company’s financial health, especially concerning its debt burden. Therefore, it is an important metric to measure a company’s ability to pay interest expenses on its outstanding debt. We then relate it to approximately how much money was recorded, in which case, we use EBIT as a proxy.
Creditors and bondholders pay attention to this ratio when making credit decisions. For example, they use it to determine a company’s risk relative to its current debt and its capacity to repay its debt.
When a company has more than adequate EBIT or even far exceeds interest payments, that’s a good sign. The company is unlikely to experience repayment problems. As a result, creditors will feel comfortable extending or offering new debt to the company.
Conversely, if the EBIT is inadequate, it could signal financial difficulties. As a result, creditors may only be willing to lend their money on more stringent terms. And, they will likely ask for higher interest to compensate for the higher risk. Or, in fact, they are willing to do it at all because the risk is higher than they can tolerate.
How to calculate the interest coverage ratio?
Calculating the interest coverage ratio requires us to compare EBIT to interest expense. In addition, we may have to calculate EBIT manually because, in some cases, the company does not present it on the income statement.
Meanwhile, interest expense can be found several lines after operating profit. For example, suppose the company presents only a net financial expense. In that case, we must examine the details in the notes to the financial statements. We may find several accounts there, such as interest income, interest expense, and rental expense.
- Interest coverage ratio = EBIT / Interest expense
For example, suppose a company posts an EBIT of $400,000 and an interest expense of $50,000. Hence, the company’s interest coverage ratio is 8.0 = $400,000 / $50,000, indicating good repayment capacity as EBIT can cover interest expense up to 8 times.
EBIT represents the profit recorded by the company before being paid to creditors as interest expense and the government as tax. Two approaches to calculating it. First, we can start with net income by adding back interest and tax expenses.
- EBIT = Net income + Interest expense + Tax expense
Second, we can start with revenue and add it to non-operating income, such as interest income. After that, we subtract the result by the cost of goods sold, operating expenses (selling, general and administrative expenses), and non-operating non-interest expenses.
- EBIT = Revenue – Cost of goods sold – Operating expenses + Non-operating income + Non-interest non-operating expenses
In certain cases, analysts usually exclude the last two components above because their values tend to be volatile over time. They can increase significantly at one time and fall sharply at another time. Since paying interest expenses requires steady cash flow, excluding them is reasonable. And, if we exclude them, EBIT will equal operating profit.
EBITDA as an alternative to EBIT
Earnings before depreciation, interest, and tax amortization (EBITDA) is an alternative metric to EBIT in the calculations above. Some analysts prefer it over EBIT because it is a better proxy for measuring the actual cash generated by a company. In addition, the figure is closer than EBIT. After all, paying interest is using cash, not profit.
EBITDA is preferred because it excludes non-cash items, namely depreciation, and amortization, from the calculation. We calculate it by adjusting our previously obtained EBIT with depreciation and amortization expenses.
And, because we’re using it as the numerator, using EBITDA in calculating the interest coverage ratio will result in a higher ratio than using EBIT.
How to interpret the interest coverage ratio?
A higher ratio is preferred because the company generates more profit to pay the interest on the debt. So, we can say the company can better pay interest.
Conversely, a lower ratio is less preferable. The lower it is, the more doubtful the company’s ability to pay its regular bills is.
If the ratio equals 1, EBIT can only cover the interest once. This situation indicates serious difficulties in paying interest. And, if it’s lower, it’s even worse.
If it does not have sufficient cash balances, the company is more likely to fall into bankruptcy. In this condition, borrowing to cover payments will be difficult because creditors no longer trust the company.
What is the ideal interest coverage ratio?
There are no exact figures about the ideal interest coverage ratio. A coverage ratio of 1.5 times is considered a minimum in certain cases. The lower, the worse. But, again, 1.5 times is not the ideal level for all companies.
Creditors may still tolerate relatively low ratios for companies with stable cash inflows, such as utility companies. Likewise, established companies can be more tolerated than new companies because of a more proven track record and more stable cash flow.
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