What Is the Interest Coverage Ratio?
The interest coverage ratio is a debt and profitability ratio used to determine how easily a company can pay interest on its outstanding debt. The interest coverage ratio may be calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense during a given period.
The interest coverage ratio is sometimes called the times interest earned (TIE) ratio. Lenders, investors, and creditors often use this formula to determine a company's riskiness relative to its current debt or for future borrowing.
- The interest coverage ratio is used to measure how well a firm can pay the interest due on outstanding debt.
- Also called the times interest earned ratio, this ratio is used by creditors and prospective lenders to assess the risk of lending capital to a firm.
- A higher coverage ratio is better, although the ideal ratio may vary by industry.
Interest Coverage Ratio
The Formula for the Interest Coverage Ratio
Interest Coverage Ratio=Interest ExpenseEBITwhere:
Understanding the Interest Coverage Ratio
The interest coverage ratio measures how many times a company can cover its current interest payment with its available earnings. In other words, it measures the margin of safety a company has for paying interest on its debt during a given period.
The ratio is calculated by dividing a company's 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.
Companies need to have more than enough earnings to cover interest payments in order to survive future, and perhaps unforeseeable, financial hardships that may arise. A company’s ability to meet its interest obligations is an aspect of its solvency and is thus an important factor in the return for shareholders.
How to Use the Interest Coverage Ratio
Interpretation is key when it comes to using ratios in company analysis. While looking at a single interest coverage ratio may reveal a good deal about a company’s current financial position, analyzing interest coverage ratios over time will often give a much clearer picture of a company’s position and trajectory.
By analyzing interest coverage ratios on a quarterly basis for the past five years, for example, trends may emerge and give an investor a much better idea of whether a low current interest coverage ratio is improving or worsening, or if a high current interest coverage ratio is stable. The ratio may also be used to compare the ability of different companies to pay off their interest, which can help when making an investment decision.
Generally, stability in interest coverage ratios is one of the most important things to look for when analyzing the interest coverage ratio in this way. A declining interest coverage ratio is often something for investors to be wary of, as it indicates that a company may be unable to pay its debts in the future.
Looking at the interest coverage ratio at one point in time can help tell analysts a bit about the company’s ability to service its debt, but analyzing the interest coverage ratio over time will provide a clearer picture of whether or not the debt is becoming a burden on the company’s financial position.
Overall, the interest coverage ratio is a good assessment of a company’s short-term financial health. While making future projections by analyzing a company’s interest coverage ratio history may be a good way of assessing an investment opportunity, it is difficult to accurately predict a company’s long-term financial health with any ratio or metric.
Moreover, the desirability of any particular level of this ratio is in the eye of the beholder to an extent. Some banks or potential bond buyers may be comfortable with a less desirable ratio in exchange for charging the company a higher interest rate on their debt.
Example of the Interest Coverage Ratio
Suppose that a company’s earnings during a given quarter are $625,000 and that it has debts upon which it is liable for payments of $30,000 every month. To calculate the interest coverage ratio here, one would need to convert the monthly interest payments into quarterly payments by multiplying them by three. The interest coverage ratio for the company is $625,000 / $90,000 ($30,000 x 3) = 6.94.
Staying above water with interest payments is a critical and ongoing concern for any company. As soon as a company struggles with this, it may have to borrow further or dip into its cash reserve, which is much better used to invest in capital assets or for emergencies.
An interest coverage ratio of 1.5 is generally considered a minimum acceptable ratio for a company and the tipping point below which lenders will likely refuse to lend the company more money, as the company’s risk for default may be perceived as too high.
Moreover, an interest coverage ratio below one indicates the company is not generating sufficient revenues to satisfy its interest expenses. If a company’s ratio is below one, it will likely need to spend some of its cash reserves in order to meet the difference or borrow more, which will be difficult for the reasons stated above. Otherwise, even if earnings are low for a single month, the company risks falling into bankruptcy.
Although it creates debt and interest, borrowing has the potential to positively affect a company’s profitability through the development of capital assets according to the cost-benefit analysis. But a company must also be smart in its borrowing. Because interest affects a company’s profitability as well, a company should only take a loan if it knows it will have a good handle on its interest payments for years to come.
A good interest coverage ratio would serve as a good indicator of this circumstance and potentially as an indicator of the company’s ability to pay off the debt itself as well. Large corporations, however, may often have both high-interest coverage ratios and large borrowings. With the ability to pay off substantial interest payments on a regular basis, large companies may continue to borrow without much worry.
Businesses may often survive for a long time while only paying off their interest payments and not the debt itself. Yet, this is often considered a dangerous practice, particularly if the company is relatively small and thus has low revenue compared to larger companies. Moreover, paying off the debt helps pay off interest down the road, as with reduced debt the company frees up cash flow and the debt's interest rate may be adjusted as well.
Limitations of the Interest Coverage Ratio
Like any metric attempting to gauge the efficiency of a business, the interest coverage ratio comes with a set of limitations that are important for any investor to consider before using it.
For one, it is important to note that interest coverage is highly variable when measuring companies in different industries and even when measuring companies within the same industry. For established companies in certain industries, such as a utility company, an interest coverage ratio of two is often an acceptable standard.
A well-established utility will likely have consistent production and revenue, particularly due to government regulations, so even with a relatively low-interest coverage ratio, it may be able to reliably cover its interest payments. Other industries, such as manufacturing, are much more volatile and may often have a higher minimum acceptable interest coverage ratio of three, for example.
These kinds of companies generally see greater fluctuation in business. For example, during the recession of 2008, car sales dropped substantially, hurting the auto manufacturing industry. A workers’ strike is another example of an unexpected event that may hurt interest coverage ratios. Because these industries are more prone to these fluctuations, they must rely on a greater ability to cover their interest in order to account for periods of low earnings.
Because of such wide variations like these, when comparing companies’ interest coverage ratios, a company should be compared to others in the same industry—and, ideally, those who have similar business models and revenue numbers as well.
Furthermore, while all debt is important to take into account when calculating the interest coverage ratio, companies may choose to isolate or exclude certain types of debt in their interest coverage ratio calculations. As such, when considering a company’s self-published interest coverage ratio, it's important to determine if all debts were included, or otherwise calculate the interest coverage ratio independently.
Variations on the Interest Coverage Ratio
A couple of somewhat common variations of the interest coverage ratio are important to consider before studying the ratios of companies. These variations come from alterations to EBIT in the numerator of interest coverage ratio calculations.
One such variation uses earnings before interest, taxes, depreciation, and amortization (EBITDA) instead of EBIT in calculating the interest coverage ratio. Because this variation excludes depreciation and amortization, the numerator in calculations using EBITDA will often be higher than those using EBIT. Since the interest expense will be the same in both cases, calculations using EBITDA will produce a higher interest coverage ratio than calculations using EBIT.
Another variation uses earnings before interest after taxes (EBIAT) instead of EBIT in interest coverage ratio calculations. This has the effect of deducting tax expenses from the numerator in an attempt to render a more accurate picture of a company’s ability to pay its interest expenses. Because taxes are an important financial element to consider, for a clearer picture of a company’s ability to cover its interest expenses, EBIAT can be used to calculate interest coverage ratios instead of EBIT.
All of these variations in calculating the interest coverage ratio use interest expenses in the denominator. Generally speaking, these three variants increase in conservatism, with those using EBITDA being the most liberal, those using EBIT the most conservative, and those using EBIAT the most stringent.
Frequently Asked Questions
What does the interest coverage ratio tell you?
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. 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.
How is the interest coverage ratio calculated?
The ratio is calculated by dividing EBIT (or some variation thereof) by interest on debt expenses (the cost of borrowed funding) during a given period, usually annually.
What is a good interest coverage ratio?
A ratio above one indicates that a company can service the interest on its debts using its earnings or has shown the ability to maintain revenues at a fairly consistent level. An interest coverage ratio of two or better may be minimally acceptable to analysts or investors. For companies with historically more volatile revenues, the interest coverage ratio may not be considered good unless it is well above three.
What does a bad interest coverage ratio indicate?
A bad interest coverage ratio is any number below one as this means that the company's current earnings are insufficient to service its outstanding debt. The chances of a company being able to continue to meet its interest expenses on an ongoing basis are still doubtful even with an interest coverage ratio below 1.5, especially if the company is vulnerable to seasonal or cyclical dips in revenues.