Interest coverage ratio

Interest coverage ratio

The interest coverage ratio measures the ease at which a company can pay interest on its outstanding debts with its earnings. It is categorized under coverage ratios that provide useful metrics to help ascertain a company's ability to service its debts and meet a broad range of financial obligations, including interest payments, and dividends, among other things.

It is calculated by dividing the company's earnings before interest and taxes (EBIT) during the period in question by the total interest expenses due towards the end of the same period. This metric offers a lot of value for financial institutions, analysts, investors, lenders, and creditors, when it comes to determining the creditworthiness or riskiness of a business before making investment decisions.

A high-interest coverage ratio indicates that a company has sufficient earnings to cover interest payments many times over, whereas a low ratio signals higher risks of default and a relatively smaller margin of safety against broader uncertainties. As such, the interest coverage ratio is also referred to as the "times interest earned" ratio.

What is the interest coverage ratio?

As the name implies, coverage in the interest coverage ratio refers to the length of time, either a number of quarters or years, for which a company's current earnings can cover its interest payments. 

It is worth noting, however, that this ratio does not concern itself with the repayment of the principal amount, which can be ascertained with the help of another similar metric, the debt-service coverage ratio (DSCR).

The interest coverage ratio formula

As discussed earlier, the interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its total interest expenses during a period. This is better illustrated by the formula below,

Interest coverage ratio = Earnings before interest & taxes (EBIT) / Total interest expense

The ratio uses earnings before interest and taxes to arrive at the accurate figure because the tax liability is calculated on the net profit that is arrived at after interest expenses. Similarly, not deducting interest expenses will result in a flawed figure and double-counting.

Example of the interest coverage ratio

To make things perfectly clear, here is an example of a fictional company, D Corporation, which generated earnings to the tune of $120,000 during the quarter before interest and taxes while incurring net interest expenses worth $10,000 per month. 

In order to calculate D Corporation's interest coverage ratio, we will first have to compute its interest expenses for the quarter ($10,000 X 3 months = $30,000), following which it can be divided by the EBIT figure as per the formula mentioned above. Therefore, $120,000 / $30,000 = 4 times coverage. 

This means that D Corporation's earnings can cover its interest expenses 4 times over, leaving it with plenty of capacity to take on more debt, with a substantial margin of safety in the case of uncertainties or unforeseen events.

Different types of interest coverage ratios

Interest coverage ratios come with a few variances, aimed at including certain other income statement and balance sheet elements to support different use cases and end users.

EBITDA (Earnings before interest, taxes, depreciation & amortization)

With this, the ratio goes beyond just interest and taxes to exclude even depreciation and amortization, which are non-cash expenses, and thus don't have any bearing on a company's immediate liquidity. As a result, the EBITDA-to-interest coverage ratio paints a more flattering picture, with higher coverage than mere EBIT figures.

Companies often present this figure when applying for loans or presenting information to shareholders. However, most qualified analysts can look past this and decipher the long-term implications of depreciation and amortization to ascertain creditworthiness. 

EBIAT (Earnings before interest after taxes)

This metric provides a truer picture of operational performance by eliminating any tax benefits gained by debt financing. It is a much more conservative metric, showing the underlying profitability without considering the company's capital structure.

Given that the EBIAT eliminates all elements that stand to boost figures in a company's favor, it is often used by lenders, investors, and financial institutions to ascertain the actual risks and creditworthiness of a business without a 'tax shield' misleading them.

DSCR (Debt service coverage ratio)

While technically not a variant of the interest rate coverage ratio, it is still an important metric among liquidity and solvency metrics. Since most debts require a principal component to be repaid along with interest, it makes sense to test a company's coverage by putting earnings up against the total debt servicing obligations during a period of time.

This ratio stands to provide a much more comprehensive picture of a company's liquidity and ability to take on more debt. This is why it remains broadly used among lenders and investors while having plenty of internal use cases as well for budgeting, decision-making, and more.

The importance of the interest coverage ratio

In order for the company to remain operational and stave off default, it has to generate sufficient earnings to cover its interest payments, among other financial obligations.

If a company has to remain a going concern, it is essential for it to stay above the water when it comes to interest payments. Without this, it will be forced to either dig into cash reserves or borrow further to merely service existing interest payments, eventually resulting in an endless debt trap that can take it under. As a result, it is crucial for any business to maintain an interest coverage ratio of at least 2 times.

Beyond just the immediate liquidity profile, or the ability to cover interest rates in the short run, analyzing this ratio over a period gives investors a good picture of a company's trajectory. Ideally, the coverage ratio should be trending upwards, with a lesser share of earnings going towards interest payments, leaving more available for dividends or business expansion.

On the other hand, if a company continues to witness a decline in this regard, it points toward deteriorating finances, mismanagement, or severe rot in its business and operations. A company that continues to see coverage drop will eventually be forced to cut dividends, borrow more, or even default, destroying value for shareholders, creditors, and lenders.

That being said. However, the desired coverage ratio often depends on the user, business, and even the industry in which a business operates. For example, investors interested in riskier bonds might be willing to consider companies with low coverage in return for higher APRs. Similarly, most REITs, or mREITs, have low coverage ratios, given their high leverage and regular dividends, which isn't necessarily bad.

Understanding the limitations of interest coverage ratio

Despite being widely used, the interest coverage ratio comes with its share of limitations that users need to understand.

Variability across industries

The core shortcoming that has been touched on above is the lack of a uniformly acceptable coverage ratio across companies and industries. 

There are certain sectors that have historically had lower interest coverage ratios owing to their capital requirements or the nature of business. Ideally, this ratio should be compared among companies within the same industry to be useful. 

Does not consider cash flows

When it comes to the immediate liquidity of a company, beyond the earnings, it is the cash flow from operating activities that matter the most. The earnings that a company generates, even after taking out most non-cash expenses and factors, may not accurately reflect the cash generated over a period and can result in liquidity issues.

Although quite rare, especially with the numerous short-term liquidity sources such as factoring and lines of credit, users must still be aware of the shortcoming of just sticking with earnings without any consideration for cash flows.

Periods of fluctuations  

The earnings of a company may be weighed down by a variety of immediate factors that may not reflect the long-term prospects or the overall fundamentals. In such cases, relying solely on the interest coverage ratio stands to mislead users, with a low coverage during the period in question.

There are a number of examples of this, most recently involving the hotel industry during COVID lockdowns and travel bans, which saw earnings decline to all-time lows before rebounding in the Spring of 2022. Ideally, lenders, investors, and analysts should make use of other metrics along with this to arrive at the most accurate picture.

Final words

The interest coverage ratio is a widely used metric that is simple to calculate and understand, providing users with a reasonably accurate understanding of a company's financial health and ability to meet interest expenses. 

Used alongside other key metrics and ratios, along with a deeper understanding of accounting and financial statements, it should allow users to uncover deep insights into a company that can guide investment, lending, financing, and other decisions.

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Frequently Asked Questions

What is a good interest coverage ratio?

No figure can be universally ascertained as a good interest rate coverage ratio. The ideal ratio differs based on the company, age, business model, and the sector in which it operates. 

What does a 1.5 coverage ratio mean?

An interest coverage ratio of 1.5 means that a company's earnings cover its interest expenses during the same period by 1.5 times.

Is a higher or lower interest coverage ratio better?

Given that this ratio ascertains the number of times a company's earnings can cover its interest obligations, a higher interest coverage ratio is always better. 

What does a negative interest coverage ratio indicate?

When a company's interest coverage ratio turns negative, it indicates that the company isn't generating sufficient earnings to pay its interest obligations. If this persists, it might soon run out of liquidity to service any of its debt or the financial obligation. 

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