The interest coverage ratio is a formula used to measure a company’s ability to cover its existing debts. The interest coverage ratio measures the time frame it will take a company to pay off its debts, should its existing revenue stay the same. The ratio is used by a variety of lenders and investors to determine the financial health and viability of a company.
Generally speaking, companies need to take on some level of debt in order to reach their growth objectives. Growth trajectory, business plans, asset-backed securitization, and market timing are all elements most lenders consider when deciding whether to lend to a company. However, calculating the financial health underneath the hood of a company is imperative to make sure that it’s a smart idea to lend it money or invest.
There are different ratios and metrics used for this purpose. One of the main metrics currently used when analyzing a company’s financial health is the interest coverage ratio.
Interest coverage ratio 101
A company’s interest coverage ratio refers to its ability to pay the interest on any debt that it might take out. Interest coverage ratio refers to the time frame it will take to pay off all of the company’s debts should the status quo of earnings remain the same. It refers to the amount of time a company will need in fiscal years to pay off all of its earnings.
If a company has a high interest coverage ratio, then they have a financial cushion that will allow them to pay its debts, even in the event of a market downturn. If a company has a low interest coverage ratio, then it may have difficulty meeting the interest payments on its debt. For investors and lenders, the interest coverage ratio is one of the most important factors when calculating if this is something to place capital in, either debt or equity.
The ratio is linked to a formula that involves the cash-flow metric EBIT or EBITDA.
EBIT vs. EBITDA
In order to understand the interest coverage formula, it’s important to understand the cash-flow metrics EBIT and EBITDA. Both of these are commonplace methods to measure a company’s financial health, based on its cash flow and earnings.
- EBIT stands for earnings before interest and taxes. This is the money that a company earns in revenue before it must meet any of its tax or debt obligations.
- EBITDA stands for earnings before interest, taxes, depreciation, and amortization. EBITDA works similarly to EBIT but takes into account if a company has assets. The depreciation and amortization allow a company to mathematically represent its assets to give a clearer picture of the company’s financial situation.
Interest coverage ratio formula
To give an example of how the equation works, we will choose to use EBIT for illustrative purposes. The mathematical formula for interest coverage ratio is as follows:
How to use the interest coverage ratio formula
As mentioned previously, the company’s EBIT represents its earnings before calculating any liability for interest and taxes. The company’s EBIT is then divided by the annual interest expense to calculate a ratio.
For example, let’s say that there are two different beverage companies you want to invest in. You have a look at both company’s books and discover the following:
|Company 1||Company 2|
|Company 1 has an EBIT of $2,000,000 a year. This is the revenue this company receives before calculating any interest or taxes. Company 1 also has outstanding interest payments of $500,000 per year.||Company 2 has an EBIT of $1,000,000 a year. However, Company 2 took on a bunch of outstanding debt as well, at $600,000 a year.|
|$2,000,000 (EBIT)/$500,000 (Interest Payments)||$1,0000,000 (EBIT)/$600,000 (Interest Payments)|
|= 4 or 4:1 ratio||= 1.67, or 1.67:1 ratio|
A company with a higher interest coverage ratio will be a safer investment (in this case, Company 1).
In a fiscal year, with the current status quo for revenue, Company 1 could pay off all of its interest four times. Company 2, on the other hand, would only be able to pay off its interest 1.67 times. Thus, in the case of an unexpected shock or fiscal downturn, Company 1 has a larger financial cushion in which to operate.
Interest coverage ratio industry practice and standards
The golden number for a good interest coverage ratio is 2. That is considered the absolute minimum ratio that would be deemed safe for investment or lending. Many analysts consider a ratio of 3 to 4 to be the optimal interest coverage ratio. This means that the companies have enough of a financial cushion to weather any drastic changes in the market.
A ratio of anything less than 2 is not feasible if you aren’t looking to take on a lot of risks. A company that has many interest obligations in a short period might be hovering on the verge of bankruptcy. Should the winds change in the market, these will be the first dominoes to fall because of their high liability.
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The limits of interest coverage ratios
As with most financial calculations, a business’s interest coverage ratio can only provide so much information. These limitations apply particularly to established companies in specific industries.
Government or blue-chip corporate bonds
Government or large corporations with a high market cap can sometimes be worthy of investment even if they have low-interest coverage ratios. The trust in the solvency and sovereignty of the United States government, for instance, supersedes whatever interest coverage ratio it may have.
Furthermore, blue-chip stocks such as Google are able to borrow almost unlimited amounts of money easily due to their size and liquidity. Unless an unprecedented market shift were to occur, you can rest assured investing in Google even if they had an interest coverage ratio below 2.
Utilities that have implicit backing from a government can have low-interest coverage ratios, but still be good investments. This is because, like bonds, people expect a government to be able to pay its debts to operate utility companies.
For instance, even with a low interest coverage ratio, a water utility or electric dam are fairly safe investments.
Is a higher interest coverage ratio better?
Yes, a higher interest coverage ratio is always better. The higher the ratio, the more times a company can repay its debts even in the event of a market crash.
What could hurt an interest coverage ratio?
An interest coverage ratio can be hurt by a company requiring more upfront investment costs. Companies in industries like Telecoms need to invest in upfront costs like towers and cables. This means that when they take on debt for this primary investment, their interest coverage ratio could slide.
A workers’ strike may also harm a company’s interest coverage ratio, which you may see in manufacturing plants. During a workers’ strike, production slows and revenue along with it, decreasing the number of times a company can pay its debts.
What is the importance of the interest coverage ratio?
The value of the interest coverage ratio is to determine how much of a financial cushion a company will have if there is a shock or market downturn.
- The interest coverage ratio measures a company’s ability to pay interest on outstanding debt.
- If a company has a higher ratio, it means the company can pay its outstanding debt with ease. If low, it means they will struggle to pay it.
- Most investors look for an interest coverage ratio of at least 2 to indicate a company can survive an economic crash. However, depending on the industry, this ratio may be even higher.
- Some industries, such as utility companies or blue-chip stocks, can have a lower ratio and still be a reliable investment.
View Article Sources
- Interest Expense on the Debt Outstanding — TreasuryDirect
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