Debt Ratios: Interest Coverage Ratio
AAA
  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
Debt Ratios: Interest Coverage Ratio

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:
None

Commentary:
The ability to stay current with interest payment obligations is absolutely critical for a company as a going concern. While the non-payment 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 cost-benefit 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.

Debt Ratios: Cash Flow To Debt Ratio

  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
Debt Ratios: Interest Coverage Ratio
RELATED TERMS
  1. Net Premiums Written To Policyholder Surplus

    A ratio of an insurance company’s gross premiums written less ...
  2. Net Liabilities To Policyholders' Surplus

    The ratio of an insurer’s liabilities, including unpaid claims, ...
  3. Reserves To Policyholders' Surplus Ratio

    The ratio of an insurer’s reserves set aside for unpaid losses ...
  4. Insurance Regulatory Information System (IRIS)

    A collection of databases and tools used to analyze the financial ...
  5. Book Value Reduction

    Reducing the value at which an asset is carried on the books ...
  6. Deferred Tax Asset

    A deferred tax asset is an asset on a company's balance sheet ...
  1. How do you calculate retained earnings per share?

    Research the amount of retained earnings per share compared over time to understand whether or not a company uses its profits ...
  2. What are the most common leverage ratios for evaluating a company?

    Learn more about some of the most common leverage ratios used by traders to determine whether a company is using debt in ...
  3. What qualifies as "goods" in cost of goods sold (COGS)?

    Learn what qualifies as "goods" in cost of goods sold, or COGS, so you can keep an accurate record for your business' income ...
  4. How is it possible for a company to have a negative enterprise value?

    Learn about enterprise value and how value investors use it to find good companies with undervalued stocks. Negative enterprise ...
Related Tutorials
  1. Industry Handbook
    Investing Basics

    Industry Handbook

  2. Investing For Safety and Income Tutorial
    Bonds & Fixed Income

    Investing For Safety and Income Tutorial

  3. Discounted Cash Flow Analysis
    Fundamental Analysis

    Discounted Cash Flow Analysis

  4. American Depositary Receipt Basics
    Economics

    American Depositary Receipt Basics

  5. Ratio Analysis Tutorial
    Fundamental Analysis

    Ratio Analysis Tutorial

Trading Center