The interest coverage ratio measures 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 cannot grow—and may not even be able to survive—unless it can pay the interest on its existing obligations to creditors.
- A company's interest coverage ratio determines whether it can pay off its debts.
- The ratio is calculated by dividing EBIT by the company's interest expense.
- A higher interest coverage ratio means a company is more poised it is to pay its debts while the opposite is true for lower ratios.
- Creditors can use the ratio to decide whether they will lend to the company.
- A lower ratio may be unattractive to investors because it may mean the company is not poised for growth.
What Is an Interest Coverage Ratio?
As noted above, a company's interest coverage ratio is an indicator of its financial health and well-being. 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. In simpler terms, it represents how many times the company can pay its obligations using its earnings.
A company with 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.
Amazon's interest coverage ratio as of June 30, 2022.
Calculating the Interest Coverage Ratio
The interest coverage ratio is calculated 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 two—$50,000/$25,000.
You can use the formula for interest coverage ratio to calculate the ratio for any interest period including monthly or annually.
Interpreting the Interest Coverage Ratio
If a company has a low-interest coverage ratio, there's a greater chance the company won't be able to service its debt, putting it at risk of bankruptcy. In other words, a low-interest coverage ratio means there is 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 may also mean 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.
Optimal Interest Coverage Ratio
What constitutes a good interest coverage varies not only between industries but also between companies in the same industry. Here's what analysts generally consider when it comes to this metric:
- An interest coverage ratio of at least two (2) is generally considered the minimum acceptable amount for a company that has solid, consistent revenues.
- Analysts prefer to see a coverage ratio of three (3) or better.
- A coverage ratio below one (1) indicates a company cannot meet its current interest payment obligations and, therefore, is not in good financial health.
The Importance of the Interest Coverage Ratio
The interest coverage ratio is an important figure not only for creditors but also for shareholders and investors alike. Creditors want to know whether a company will be able to pay back its debt. If it has trouble doing so, there's less of a likelihood that future creditors will want to extend it any credit.
Similarly, both shareholders and investors can also use this ratio to make decisions about their investments. A company that can't pay back its debt means it will not grow. Most investors may not want to put their money into a company that isn't financially sound.
Types of Interest Coverage Ratio
There are a few different types of interest coverage ratios. Each serves a different purpose.
- EBIT Interest Coverage Ratio: This metric tells analysts the number of times that a company's EBIT is able to pay its upcoming interest expenses. This is calculated by dividing the total interest expense by a company's EBIT.
- EBITDA Interest Coverage Ratio: Divide a company's interest expense by its EBITDA to determine how many times a company's EBITDA can pay any interest expenses that are coming due.
- EBITDA Less CapEx: Find out how many times a company's EBITDA can pay its upcoming interest expenses after capital expenditures (CapEx) are deducted. The formula for this type of coverage ratio is (EBITDA – CapEx) ÷ Interest Expense
- Fixed Charge Coverage Ratio: This metric helps determine a company's ability to service all of its short- or near-term liabilities. The formula for this type of coverage ratio is (EBITDA – CapEx) ÷ (Interest Expense + Current Portion of a Company's Long-Term Debt)
Limitations of the Interest Coverage Ratio
As noted above, having a higher interest coverage ratio is usually considered desirable because it means that a company is able to better fulfill its financial obligations. But this isn't always a hard-and-fast rule. That's because this characteristic can be fairly fluid to some degree.
Higher ratios are better for companies and industries that are susceptible to volatility. But lower coverage ratios are often suitable for companies that fall in certain industries, including those that are heavily regulated. As such, don't compare companies that aren't in the same industry. For instance, it's not useful to compare a utility company (which normally has a low coverage ratio) with a retail store.
What Is the Importance of the Interest Coverage Ratio?
The interest coverage ratio is a financial metric that measures whether companies can pay their outstanding debts. The general rule is that the higher the ratio, the better position a company has to repay its interest obligations while lower ratios point to financial instability. Analysts generally look for ratios of at least two (2) while three (3) or more is preferred. A ratio of one (1) is not good.
What Does a Negative Interest Coverage Ratio Mean?
A company's interest coverage ratio can be negative. When this happens, it is under one (1). Companies that find themselves in this situation are not considered financially healthy. As such, they aren't able to keep up with their financial obligations.
How Do You Calculate the Interest Coverage Ratio?
The simple way to calculate a company's interest coverage ratio is by dividing its EBIT (the earnings before interest and taxes) by the total interest owing on all of its debts.
The Bottom Line
There are many metrics that can help you determine the financial health and well-being of companies and, therefore, your investment portfolio. One of those is the interest coverage ratio. This figure measures a company's ability to cover its interest obligations. Knowing how to calculate it and using it with other valuable financial metrics can help you become a well-informed investor so you can make better decisions about your investments.