A:

The interest coverage ratio is one of several debt ratios that market analysts utilize. The formula allows investors or analysts to determine how comfortably interest on all its outstanding debt can be paid by a company. The ratio is calculated by using the interest expenses (the cost of borrowed funding) of a company during a given period of time, usually annually, to divide its earnings before interest and taxes over that same period of time. The equation is as follows:

Interest Coverage Ratio = Earnings Before Interest and Tax (EBIT) / Interest on debt expenses

A bad interest coverage ratio is any number below 1, as this translates to the company's current earnings being insufficient to service the company's currently outstanding debt. The chances of a company being able to continue to meet its interest expenses are doubtful even with an interest coverage ratio below 1.5, especially if the company is vulnerable to seasonal or cyclical dips in income.

Although a company with difficulties servicing its debt may manage to stay financially afloat for a significant period of time, it is vital for analysts and investors to stay abreast of the company’s ability to pay off interest obligations. A low interest coverage ratio is a definite red flag for investors, as it can be an early warning signal of impending bankruptcy.

The number that constitutes a good, or at least minimally acceptable, interest coverage ratio varies according to the type of business a company is engaged in, as well as the company's individual history of month-to-month or year-to-year revenues. For a company that has shown the ability to maintain revenues at a fairly consistent level, an interest coverage ratio of 2 or better may be minimally acceptable to analysts or investors. For companies with revenues that have historically been more volatile, the interest coverage ratio may not be considered a good one unless it is well above 3.

RELATED FAQS
  1. 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 ... Read Answer >>
  2. Which types of coverage ratios should I look at when deciding to invest in a company?

    Find out why coverage ratios are useful for investors to know and which three coverage ratios an investor should understand ... Read Answer >>
  3. How does the International Monetary Fund function?

    Learn how expenditures and distributions affect the fixed charge coverage ratio, and how this ratio is used to evaluate a ... Read Answer >>
  4. What's the difference between the coverage ratio and the liquidity coverage ratio?

    Understand the difference between coverage ratios and the liquidity coverage ratio and why the liquidity coverage ratio rule ... Read Answer >>
  5. What is the difference between interest coverage ratio and DSCR?

    Understand the basics of the interest coverage ratio and the debt-service coverage ratio, including calculations and how ... Read Answer >>
  6. What are financial risk ratios and how are they used to measure risk?

    Explore some of the primary financial risk ratios that investors and analysts commonly use to evaluate a company's overall ... Read Answer >>
Related Articles
  1. Investing

    How to Calculate a Coverage Ratio

    In broad terms, the higher the coverage ratio, the better the ability of the enterprise to fulfill its obligations to its lenders.
  2. Investing

    An Introduction To Coverage Ratios

    Interest coverage ratios help determine a company's ability to pay down its debt.
  3. Investing

    Analyzing Wal-Mart's Debt Ratios in 2016 (WMT)

    Analyze Wal-Mart's debt-to-equity ratio, interest coverage ratio and cash flow-to-debt ratio to evaluate the company's financial health and debt management.
  4. Investing

    Analyzing General Electric's Debt Ratios in 2016 (GE)

    Evaluate GE's debt picture using the most important metrics for a large-cap conglomerate, including the debt-to-equity (D/E) ratio and the interest coverage ratio.
  5. Investing

    Analyzing AT&T's Debt Ratios in 2016 (T)

    Learn about AT&T Inc. and its key debt ratios, such as the debt-to-equity ratio, interest coverage ratio and cash flow-to-debt ratio.
  6. Investing

    Analyze Investments Quickly With Ratios

    Make informed decisions about your investments with these easy equations.
  7. Investing

    Analyzing IBM's Debt Ratios in 2016 (IBM)

    Look over the debt ratios for the IBM Corporation, such as its debt-to-equity ratio, its interest coverage ratio and its cash flow to debt ratio.
  8. Investing

    Debt Ratios

    Learn about the debt ratio, debt-equity ratio, capitalization ratio, interest coverage ratio and the cash flow to debt ratio.
  9. Investing

    Do Your Investments Have Short-Term Health?

    If a company is strong enough to survive tough times, it is more likely to provide long-term value.
RELATED TERMS
  1. Asset Coverage Ratio

    A test that determines a company's ability to cover debt obligations ...
  2. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained ...
  3. EBITDA-To-Interest Coverage Ratio

    A ratio that is used to assess a company's financial durability ...
  4. Interest Expense

    The cost incurred by an entity for borrowed funds. Interest expense ...
  5. Coincidental Excess Coverage

    Insurance coverage that provides excess coverage for a specified ...
  6. Preferred Dividend Coverage Ratio

    A coverage ratio that measures a company's ability to pay off ...
Hot Definitions
  1. Time In Force

    Time in force is a special instruction used when placing a trade to indicate how long an order will remain active before ...
  2. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  3. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  4. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
  5. Redemption

    The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
  6. Solvency

    The ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business, but a ...
Trading Center