1. Debt Ratios: Introduction
  2. Debt Ratios: Overview Of Debt
  3. Debt Ratios: The Debt Ratio
  4. Debt Ratios: Debt-Equity Ratio
  5. Debt Ratios: Capitalization Ratio
  6. Debt Ratios: Interest Coverage Ratio
  7. Debt Ratios: Cash Flow To Debt Ratio

The interest coverage ratio is used to determine how easily a company can pay their interest expenses on outstanding debt. The ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the company's interest expenses for the same period. The lower the ratio, the more the company is burdened by debt expense. When a company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable.

The ratio measures how many times over a company could pay its outstanding debts using its earnings. This can be thought of as a margin of safety for the company’s creditors should the company run into financial difficulty down the road.

The ability to service its debt obligations is a key factor in determining a company’s solvency and is an important statistic for shareholders and prospective investors.

Investors want to be sure that a company they are considering investing in can pay its bills, including its interest expense. They don’t want the company’s growth derailed by these types of financial issues.

Creditors are concerned with the company’s ability to make their interest payments as well. If they are struggling to make the interest payments on their current debt obligations, it doesn’t make any sense for a prospective credit to extend them additional credit.

Trends over time

The interest coverage ratio at a point in time can help tell analysts a bit about the company’s ability to service its debt, but analyzing the interest coverage ratio over time will provide a clearer picture of whether or not their debt is becoming a burden on the company’s financial position. A declining interest coverage ratio is something for investors to be wary of, as it indicates that a company may be unable to pay its debts in the future. However, it is difficult to accurately predict a company’s long-term financial health with any ratio or metric.

Moreover, the desirability of any particular level of this ratio is in the eye of the beholder to an extent. Some banks or potential bond buyers may be comfortable with a less desirable ratio in exchange for charging the company a higher interest rate on their debt.


Debt Ratios: Cash Flow To Debt Ratio
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