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—the higher the ratio, the more poised it is to pay its debts.
- 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 Does Interest Coverage Ratio Mean?
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. In simpler terms, it represents how many times the company can pay its obligations using its earnings.
Amazon's interest coverage ratio as of Dec. 16, 2020.
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.
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.
You can use this formula to calculate the ratio for any interest period including monthly or annually.
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.
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. Generally, an interest coverage ratio of at least two (2) is 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. In contrast, a coverage ratio below one (1) indicates a company cannot meet its current interest payment obligations and, therefore, is not in good financial health.
Importance of Interest Coverage Ratio
This is an important figure not only for creditors, but also for shareholders and investors alike. Creditors want to know 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.