When it comes to risk management, the interest coverage ratio can be an essential tool for understanding whether your business’s revenues are high enough to pay the interest on your debt obligations. Find out everything you need to know, starting with our interest coverage ratio definition.
Interest coverage ratio definition
The interest coverage ratio, sometimes referred to as the “times interest earned” ratio, is used to determine a company’s ability to pay interest on its outstanding debt. Essentially, the ratio measures how many times a business can cover its current interest payments using its available earnings. This helps you understand your margin of safety for paying interest on debt over a given period. Most of the time, creditors, investors, and lenders use the interest coverage ratio formula to judge the risk of lending capital to a business.
Why is the interest coverage ratio important?
Businesses need to have a sufficient level of earnings to cover their interest payments. Otherwise, the business may not be able to survive any financial hardships that they encounter in the future. Put simply, your ability to pay the interest on your company’s outstanding debt is a significant factor for solvency, which means that the interest coverage ratio formula plays a significant role in determining returns for shareholders.
Also, the interest coverage ratio can give you crucial information about a company’s short-term financial health. While it’s always difficult to make predictions about your business’s long-term outlook, the interest coverage ratio formula can help you understand whether the debt is becoming a burden for your company, rather than a liability that you’re using to fund growth.
What is a good interest coverage ratio?
A “good” interest coverage ratio is likely to vary from industry to industry. For example, the average debt obligations for businesses in the manufacturing and technology industries are dramatically different. Overall, an interest coverage ratio of at least two is the minimum acceptable amount. In most cases, investors and analysts will look for interest coverage ratios of at least three, which indicate that the business’s revenues are reliable and consistent.
On the other hand, a “bad” interest coverage ratio is any number less than one, because this means that your business’s earnings aren’t sufficiently high enough to service your outstanding debt. Although it may be possible for companies that have difficulties servicing their debt to stay in business, a low or negative interest coverage ratio is usually a major red flag for investors. In many cases, it indicates that the firm is at risk of bankruptcy in the future.
Understanding the interest coverage ratio formula
The interest coverage ratio formula is as follows:
Interest Coverage Ratio = EBIT / Interest Expense
In this calculation, EBIT (earnings before interest and taxes) represents the company’s operating profit. Interest expense refers to the interest that’s payable on your business’s borrowings, including lines of credit, loans, bonds, and so on.
Let’s look at an example. Imagine that Company A has an EBIT of $40,000 and total interest expenses of £$5,000. In this scenario, the interest coverage ratio would work out to 2.66 ($40,000 / $15,000). In other words, Company A makes 2.66 more in earnings than their current interest payments, which means that it shouldn’t have any trouble making payments, as operations are producing enough revenue to pay the bills.
Interest coverage ratio variations
There are several different variations of the interest coverage ratio formula. One of the most prominent variations uses EBITDA (earnings before interest, taxes, depreciation, and amortisation) instead of EBIT. Using EBITDA in the interest coverage ratio will often give you a better result, as the calculation excludes depreciation and amortisation. As such, an EBITDA interest coverage ratio is a far more liberal take on the formula.
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