The interest coverage ratio is a measurement of a company's ability to handle its outstanding debt. It is one of a number of debt ratios that can be used to evaluate a company's financial condition. A good interest coverage ratio is considered important by both market analysts and investors, since a company can not grow, and may not even be able to survive, unless it can adequately pay the interest on its existing obligations to creditors.
The term "coverage" refers to the length of time (ordinarily the number of fiscal years) for which interest payments can be made with the company's currently available earnings. A company that has very large current earnings beyond the amount required to make interest payments on its debt has a larger financial cushion against a temporary downturn in revenues. A company barely able to meet its interest obligations with current earnings is in a very precarious financial position, as even a slight, temporary dip in revenue may render it financially insolvent.
Calculating the Interest Coverage Ratio
The interest coverage ratio is arrived by dividing earnings before interest and taxes (EBIT) by the total amount of interest expense on all of the company's outstanding debts. A company's debt can include lines of credit, loans, and bonds.
For example, if a company's earnings before taxes and interest amount to $50,000, and its total interest payment requirements equal $25,000, then the company's interest coverage ratio is 2 ($50,000/$25,000).
Interpreting the Interest Coverage Ratio
If a company has a low-interest coverage ratio, there's a greater chance that the company won't be able to service its debt and might be at risk of bankruptcy. In other words, a low-interest coverage ratio means that there are a low amount of profits available to meet the interest expense on the debt. Also, if the company has variable-rate debt, the interest expense will rise in a rising interest rate environment.
A high ratio indicates there are enough profits available to service the debt, but it could also mean that the company is not using its debt properly. For example, if a company is not borrowing enough, it may not be investing in new products and technologies to stay ahead of the competition in the long-term.
What's an Optimal Interest Coverage Ratio?
What constitutes a good interest coverage varies not only between industries but also between companies in the same industry. Generally, an interest coverage ratio of at least 2 is considered the minimum acceptable amount for a company that has solid, consistent revenues. Analysts prefer to see a coverage ratio of 3 or better. In contrast, a coverage ratio below 1 indicates that a company cannot meet its current interest payment obligations and therefore is not in good financial health.