- What is Interest Coverage Ratio?
- Interest Coverage Ratio Formula
- How to Calculate Interest Coverage Ratio?
- Interpretation of Interest Coverage Ratio
- Importance of Interest Coverage Ratio
- Variations of Interest Coverage Ratio
- Benefits of Using Interest Coverage Ratio
- Limitations of Using Interest Coverage Ratio
What is Interest Coverage Ratio?
Interest coverage ratio is an accounting ratio. It determines how many times the company can pay off the accumulated interest before taxes and interest are deducted. The ratio is commonly referred to as “times interest earned.” It does not take into consideration the principal debt repayment. It is concerned with payment of accumulated interest only.
The term “coverage” in the interest coverage ratio refers to the number of times usually quarters or financial years. It is the number of times the interest payments may be made with the company’s existing earnings.
Interest Coverage Ratio Formula
The formula for Interest Coverage Ratio is:
Interest Coverage Ratio = (EBIT / Interest Expense)
How to Calculate Interest Coverage Ratio?
The following illustration explains how to calculate interest coverage ratio using all the three variations and indirect approach.
|AmountFinancial Year 2021-2022
|AmountFinancial Year 2020-2021
(Net Operating Income + Interest + Taxes)
(Rs 9,00,000 + Rs 4,00,000 + Rs 1,00,000)
(Rs 10,00,000 + Rs 4,20,000 + Rs 1,40,000)
(Net Operating Income + Interest + Taxes + Depreciation + Amortisation)
(Rs 9,00,000 + Rs 4,00,000 + Rs 1,00,000 + Rs 80,000 + Rs 1,20,000)
(Rs 10,00,000 + Rs 4,20,000 + Rs 1,40,000 + Rs 60,000 + Rs 1,10,000)
(Net Operating Income + Interest)
(Rs 9,00,000 + Rs 4,00,000)
(Rs 10,00,000 + Rs 4,20,000)
|Interest Coverage Ratio
Method-1 (EBIT / Interest Expense)
(Rs 14,00,000 / Rs 4,00,000)
(Rs 15,60,000 / Rs 4,20,000)
|Interest Coverage Ratio
Method-2 (EBITDA / Interest Expense)
(Rs 16,00,000 / Rs 4,00,000)
(Rs 17,30,000 / Rs 4,20,000)
|Interest Coverage Ratio
Method-3 (EBIAT / Interest Expense)
(Rs 13,00,000 / Rs 4,00,000)
(Rs 14,20,000 / Rs 4,20,000)
Interpretation of Interest Coverage Ratio
Higher Interest Coverage Ratio
A ratio greater than one shows that a company can pay its debts with its earnings. The company has the ability to keep revenues stable. Moreover, a ratio of 1.5 could be considered as sufficient. Usually, analysts and investors prefer two or higher. It may not be regarded favorable for companies with historically more unpredictable revenues until it is considerably above three.
Lower Interest Coverage Ratio
Any value below one is a negative interest coverage ratio. This indicates that the company’s existing revenues are inadequate to repay its existing debt. If it is less than 1.5 shows the prospects of a company being able to fulfils its interest expenses on a continuous basis are still questionable. It is questionable especially if the company is susceptible to seasonal or cyclical revenue fluctuations.
Importance of Interest Coverage Ratio
- Many companies face the challenge of covering interest liabilities continuously. It is essential for solvency and liquidity to secure these liabilities with a revenue stream. When a company is having trouble meeting its obligations, it may have to borrow more or utilize its cash reserve. Such cash reserves would be better spent on capital assets or to meet contingencies.
- A single interest coverage ratio might disclose a lot about a company’s current financial situation. However, by considering it across time can portray a company’s position and direction.
- It is advisable to analyse the company’s interest coverage ratios periodically for the past few years. An analysis of the ratio across many financial years would showcase if the ratio is improving, dropping, or steady. It also provides a view of the short-term financial health of the company.
- Furthermore, the acceptability of any given level of this ratio is to some extent depends on the analyst. Some banks, investors, and lenders may be willing to accept a lower ratio in exchange for a higher interest rate on the company’s debt.
Variations of Interest Coverage Ratio
EBIT- Earning Before Interest and Taxes
Earning Before Interest and Taxes is the operating revenue of the organisation denoting its income generated from sales and expenses owing to its operation. There are 2 approaches to calculating EBIT. One way is to make additions to the net operating income with the interest liabilities and taxes payable. The interest and taxes are added back because they were deducted in the first place. The second approach is to simply consider the operating income line item on the profit and loss account. EBIT = Revenue – Cost of Goods Sold – Operating Expenses
EBITDA- Earning Before Interest, Taxes, Depreciation, and Amortisation
When computing the interest coverage ratio, one version (EBITDA) employs profits before interest, taxes, depreciation, and amortisation instead of EBIT. The depreciation and amortisation are excluded from the EBITDA. The value of EBITDA is usually higher than EBIT. Because the interest expense will be the same in both circumstances, EBITDA computations will result in a higher interest coverage ratio than EBIT calculations.
EBIAT- Earning Before Interest and After Taxes
The interest coverage ratio employs earnings before interest and taxes (EBIAT) rather than EBIT. EBIAT requires subtracting tax liabilities from the numerator. Hence, the EBIAT approach is a more appropriate showcase of a company’s ability to pay interest expenses. The tax liabilities are mandatory and obligatory. For many companies tax liabilities involve quite a higher rate owing to their tax structure. Hence, it makes sense to deduct it. Through this approach, EBIAT can be used to compute interest coverage ratios instead of EBIT. Like the EBITDA, EBIAT provides a better view of a company’s capacity to cover its interest costs.
Benefits of Using Interest Coverage Ratio
- It is a quite common accounting metric to analyse the risk associated with lending funds.
- It is also used by investors to determine whether the firm they are investing in is profitable.
- Borrowing does not represent inefficiency or lack of funds. A company must utilize this borrowing with utmost efficiency to build assets, expand their business, acquire new businesses, and so on. Interest payments have an impact on profitability. Hence, a business should be confident that it can handle them regularly. This ratio is useful to understand a company’s capability or financial strength to pay its debt interest.
Limitations of Using Interest Coverage Ratio
- While it is an outstanding ratio, it does have certain drawbacks. It may differ by industry, and different ratios may be acceptable in other sectors. In addition, while comparing, companies in the same industry should be chosen rather than companies from different industries, situations, or business methods.
- Due to government rules, a matured company will generally have stable production and revenue. Hence, even with a low interest coverage ratio, it may be able to cover its interest payments continuously.
- The ratio may portray a default if the interest expense is accrued during the period. However, such an interest expense is not due for payment. This debt default will not occur until the interest is due for payment.
- While calculating the ratio, a company might exclude a particular type of debt. This could be done to escalate the results in one way or the other. Hence, if an analyst is considering a ratio that is published by the company then it is prudent to check its calculations. They must check the calculation, types of debts included, and nomenclature of line items in the financial statements.