
Debt Ratios: Interest Coverage Ratio
By Richard Loth (Contact  Biography)
The interest coverage ratio is used to determine how easily a company can pay 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.
Formula:
Components:
As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had earnings before interest and taxes (operating income) of $1,055.00 (income statement), and total interest expense of $14.30 (income statement). This equation provides the company with an extremely high margin of safety as measured by the interest coverage ratio.
Variations:
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Commentary:
The ability to stay current with interest payment obligations is absolutely critical for a company as a going concern. While the nonpayment of debt principal is a seriously negative condition, a company finding itself in financial/operational difficulties can stay alive for quite some time as long as it is able to service its interest expenses.
In a more positive sense, prudent borrowing makes sense for most companies, but the operative word here is "prudent." Interest expenses affect a company's profitability, so the costbenefit analysis dictates that borrowing money to fund a company's assets has to have a positive effect. An ample interest coverage ratio would be an indicator of this circumstance, as well as indicating substantial additional debt capacity. Obviously, in this category of investment quality, Zimmer Holdings would go to the head of the class.
Let's see how the interest coverage ratio works out for IBM, Merck, Eagle Materials and Lincoln Electric: 57, 20, 39 and 20, respectively. By any standard, all of these companies, as measured by their latest FY earnings performances, have very high interest coverage ratios. It is worthwhile noting that this is one of the reasons why companies like IBM and Merck have such large borrowings  because in a word, they can. Creditors have a high comfort level with companies that can easily service debt interest payments. Here again, Zimmer Holdings, in this regard, is in an enviable position.


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