Interest Coverage Ratio

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What is the 'Interest Coverage Ratio'

The interest coverage ratio is a debt ratio and profitability ratio used to determine how easily a company can pay interest on outstanding debt. The interest coverage ratio may be calculated by dividing a company's earnings before interest and taxes (EBIT) during a given period by the amount a company must pay in interest on its debts during the same period.

The method for calculating interest coverage ratio may be represented with the following formula:

Interest Coverage Ratio 

or

Interest coverage ratio is also often called “times interest earned.”

BREAKING DOWN 'Interest Coverage Ratio'

Essentially, the interest coverage ratio measures how many times over a company could pay its current interest payment with its available earnings. In other words, it measures the margin of safety a company has for paying interest during a given period, which a company needs in order to survive future (and perhaps unforeseeable) financial hardship should it arise. A company’s ability to meet its interest obligations is an aspect of a company’s solvency, and is thus a very important factor in the return for shareholders.

To provide an example of how to calculate interest coverage ratio, suppose that a company’s earnings during a given quarter are $625,000 and that it has debts upon which it is liable for payments of $30,000 every month. To calculate the interest coverage ratio here, one would need to convert the monthly interest payments into quarterly payments by multiplying them by three. The interest coverage ratio for the company is then 6.94 [$625,000 / ($30,000 x 3) = $625,000 / $90,000 = 6.94].

Staying above water with paying interest is a critical and ongoing concern for any company. As soon as a company struggles with this, it may have to borrow further or dip into its cash, which is much better used to invest in capital assets or held as reserves for emergencies.

The lower a company’s interest coverage ratio is, the more its debt expenses burden the company. When a company's interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable. 1.5 is generally considered to be a bare minimum acceptable ratio for a company and a tipping point below which lenders will likely refuse to lend the company more money, as the company’s risk for default is too high.

Moreover, an interest coverage ratio below 1 indicates the company is not generating sufficient revenues to satisfy its interest expenses. If a company’s ratio is below 1, it will likely need to spend some of its cash reserves in order to meet the difference or borrow more, which will be difficult for reasons stated above. Otherwise, even if earnings are low for a single month, the company risks falling into bankruptcy.

Generally, an interest coverage ratio of 2.5 is often considered to be a warning sign, indicating that the company should be careful not to dip further.

Even though it creates debt and interest, borrowing has the potential to positively affect a company’s profitability through the development of capital assets according to the cost-benefit analysis. But a company must also be smart in its borrowing. Because interest affects a company’s profitability as well, a company should only take a loan if it knows it will have a good handle on its interest payments for years to come. A good interest coverage ratio would serve as a good indicator of this circumstance, and potentially as an indicator of the company’s ability to pay off the debt itself as well. Large corporations, however, may often have both high interest coverage ratios and very large borrowings. With the ability to pay off large interest payments on a regular basis, large companies may continue to borrow without much worry.

Businesses may often survive for a very long time while only paying off their interest payments and not the debt itself. Yet, this is often considered a dangerous practice, particularly if the company is relatively small and thus has low revenue compared to larger companies. Moreover, paying off the debt helps pay off interest down the road, as with reduced debt the interest rate may be adjusted as well.

Uses of 'Interest Coverage Ratio'

While looking at a single interest coverage ratio may tell a good deal about a company’s current financial position, analyzing interest coverage ratios over time will often give a much clearer picture about a company’s position and trajectory. By analyzing interest coverage ratios on a quarterly basis for the past five years, for example, trends may emerge and give an investor a much better idea of whether a low current interest coverage ratio is improving or worsening, or if a high current interest coverage ratio is stable. The ratio may also be used to compare the ability of different companies to pay off their interest, which can help when making an investment decision.

Generally, stability in interest coverage ratios is one of the most important things to look for when analyzing the interest coverage ratio in this way. A declining interest coverage ratio is often something for investors to be wary of, as it indicates that a company may be unable to pay its debts in the future.

Overall, interest coverage ratio is a very good assessment of a company’s short-term financial health. While making future projections by analyzing a company’s interest coverage ratio history may be a good way of assessing an investment opportunity, it is difficult to accurately predict a company’s long-term financial health with any ratio or metric.

Variations of 'Interest Coverage Ratio'

There are a couple of somewhat common variations of interest coverage ratio that are important to consider before studying the ratios of companies. These variations come from alterations to EBIT in the numerator of interest coverage ratio calculations. 

One such variation uses earnings before interest, taxes, depreciation and amortization (EBITDA) instead of EBIT in calculating the interest coverage ratio. Because this variation excludes depreciation and amortization, the numerator in calculations using EBITDA will often be higher than those using EBIT. Because the interest expense will be the same in both cases, calculations using EBITDA will produce a higher interest coverage ratio than calculations using EBIT will.

Another variation uses earnings before interest after taxes (EBIAT) instead of EBIT in interest coverage ratio calculations. This has the effect of deducting tax expenses from the numerator in an attempt to render a more accurate picture of a company’s ability to pay its interest expenses. Because taxes are an important financial element to consider, for a clearer picture of a company’s ability to cover its interest expenses one might use EBIAT in calculating interest coverage ratios instead of EBIT.

All of these variations of calculating the interest coverage ratio use interest expenses in the denominator. Generally speaking, these three variants increase in conservatism, with those using EBITDA being the most liberal, those using EBIT being more conservative, and those using EBI being the most stringent.

Limitations of 'Interest Coverage Ratio'

Like any metric attempting to gauge the efficiency of a business, the interest coverage ratio comes with a set of limitations that are important for any investor to consider before using it.

For one, it is important to note that interest coverage is highly variable, both when measuring companies in different industries and even when measuring companies within the same industry. For established companies in certain industries, like a utility company, an interest coverage ratio of 2 is often an acceptable standard. Even though this is a low number, a well-established utility will likely have very consistent production and revenue, particularly due to government regulations, so even with a relatively low interest coverage ratio it may be able to reliably cover its interest payments. Other industries, like many kinds of manufacturing, are much more volatile and may often have a higher minimum acceptable interest coverage ratio, like 3. These kinds of companies generally see greater fluctuation in business. For example, during the recession of 2008, car sales dropped substantially, hurting the auto manufacturing industry. A workers’ strike is another example of an unexpected event that may hurt interest coverage ratios. Because these industries are more prone to these fluctuations, they must rely on a greater ability to cover their interest in order to account for periods of low earnings. Because of wide variations like these, when comparing companies’ interest coverage ratios one should be sure to only compare companies in the same industry, and ideally when the companies have similar business models and revenue numbers as well.

While all debt is important to take into account when calculating the interest coverage ratio, companies may choose to isolate or exclude certain types of debt in their interest coverage ratio calculations. As such, when considering a company’s self-published interest coverage ratio, one should try to determine if all debts were included, or should otherwise calculate interest coverage ratio independently.

To understand more on the importance of this ratio, read Why Interest Coverage Matters To Investors and Debt Ratios: Interest Coverage Ratio.

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