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

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. Development To Policyholder Surplus

    The ratio of an insurer’s loss reserve development to its policyholders’ ...
  2. Earned Premium

    The amount of total premiums collected by an insurance company ...
  3. Net Premiums Written To Policyholder Surplus

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

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

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

    A collection of databases and tools used to analyze the financial ...
  1. What is a good gearing ratio?

    Understand the meaning of the gearing ratio, how it is calculated, the definition of high and low gearing, and how they reflect ...
  2. What is a good interest coverage ratio?

    Learn the importance of the interest coverage ratio, one of the primary debt ratios analysts use to evaluate a company's ...
  3. What is a bad interest coverage ratio?

    Understand how interest coverage ratio is calculated and what it signifies, and learn what market analysts consider to be ...
  4. What is considered to be a bad gearing ratio?

    Understand the basics of gearing, including the net gearing ratio, what constitutes a bad gearing ratio and how this figure ...

You May Also Like

Related Tutorials
  1. Investing Basics

    Industry Handbook

  2. Bonds & Fixed Income

    Investing For Safety and Income Tutorial

  3. Fundamental Analysis

    Discounted Cash Flow Analysis

  4. Fundamental Analysis

    Ratio Analysis Tutorial

  5. Economics

    American Depositary Receipt Basics

Trading Center