Debt Ratios: Interest Coverage 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

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
RELATED TERMS
  1. Short-Term Debt

    An account shown in the current liabilities portion of a company's ...
  2. PIPE Deal

    Signifying "Private Investment in Public Equity," a PIPE deal ...
  3. Audit

    An unbiased examination and evaluation of the financial statements ...
  4. IRR Rule

    A measure for evaluating whether to proceed with a project or ...
  5. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  6. Discounted Payback Period

    A capital budgeting procedure used to determine the profitability ...
RELATED FAQS
  1. What is a good debt ratio, and what is a bad debt ratio?

    Debt ratios can be used to describe the financial health of individuals, businesses or governments. Like other accounting ... Read Full Answer >>
  2. When does a growth stock turn into a value opportunity?

    A growth stock turns into a value opportunity when it trades at a reasonable multiple of the company's earnings per share ... Read Full Answer >>
  3. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  4. What items are considered liquid assets?

    A liquid asset is cash on hand or an asset that can be readily converted to cash. An asset that can readily be converted ... Read Full Answer >>
  5. What is the 'Rule of 72'?

    The 'Rule of 72' is a simplified way to determine how long an investment will take to double, given a fixed annual rate of ... Read Full Answer >>
  6. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
Trading Center