Interest Coverage Ratio

The interest coverage ratio is a measure of a company’s ability to meet interest payments on its debt. It is calculated by dividing EBIT (earnings before interest and taxes) by interest expense. A high interest coverage ratio indicates that the company has a low debt burden and is able to easily meet its interest obligations. A low interest coverage ratio indicates that the company has a high debt burden and may be at risk of defaulting on its debt.

Formula:

Interest Coverage Ratio = EBIT / Interest Expense

Interpretation:

• High interest coverage ratio: Indicates a low debt burden and an ability to easily meet interest payments.
• Low interest coverage ratio: Indicates a high debt burden and may increase the risk of default.
• Interest coverage ratio of 1: Indicates that the company is just barely able to meet its interest payments.
• Interest coverage ratio greater than 1: Indicates that the company has excess cash flow and can afford to have a higher debt burden.
• Interest coverage ratio less than 1: Indicates that the company may have difficulty meeting its interest payments.

Uses:

• To assess a company’s ability to meet interest payments.
• To evaluate a company’s debt burden and risk of default.
• To compare companies with different debt levels.
• To gauge a company’s financial strength and resilience.

Factors Affecting Interest Coverage Ratio:

• EBIT (earnings before interest and taxes)
• Interest expense
• Debt level
• Interest rate
• Industry conditions
• Company size and industry

Note:

The interest coverage ratio is a useful metric for analyzing a company’s financial health, but it should not be used in isolation. Other financial ratios and metrics should also be considered to provide a more comprehensive view of a company’s ability to meet its debt obligations.