Nowadays, leverage has been a principal instrument in the corporate world, and it is also a crucial tool required for the expansion of a business.
However, the other side of leverage can be risky.
Debt obligations might become burdensome for a business if they are rising at a more incredible speed than the business operations.
Savvy investors are known for assessing such risks before investing in a company. How?
An interest coverage ratio is a crucial tool for risk management.
The interest coverage ratio is a metric that can determine how easily a company can pay the interest on its debt with its current earnings. It gives you valuable insights into the current financial health of a company. The value of this ratio determines the number of times a company can pay its debt interest with its current earnings.
A higher value provides a better safety net for the investors, thereby helping them make safe and well-informed investment choices.
Read ahead to learn everything about how the interest coverage ratio is capable of helping investors make intelligent investing decisions.
The interest coverage ratio, also known as the times interest earned ratio, is a debt and profitability ratio. It represents the ability of a company to pay the interest on its debts with its current earnings.
The term ”coverage” stands for the number of times or financial years a company can make interest payments with the current revenue earned by the company.
Investors use this ratio to assess a company’s financial health, while creditors also use this ratio to determine a company’s creditworthiness.
The interest coverage ratio is the proportion of earnings before interest and tax to the total interest on the debt.
The formula for interest coverage ratio is as follows:
Interest coverage ratio = Earnings before interest and tax / Interest expense.
The formula for interest coverage ratio comprises two main components, and they are:
Earnings before interest and tax generally refer to a company’s operating profit.
The interest expense is the interest payable on the company’s outstanding debt, and the interest is calculated on various business borrowings like loans and bonds.
Let us understand an example to gain clarity about the interest coverage ratio.
Assume a company named Makati Limited whose earnings during a given quarter are INR 7,55,000. The information provided from the accounting books of Makati Limited tells us that it has debts for which it must pay INR 42,000 every month.
We are required to calculate the interest coverage ratio for Makati Limited for this quarter.
To calculate the interest coverage ratio, we need to have information about two main components: Earnings before interest and tax and interest expense.
We already know that,
Earnings before interest and tax for the quarter = INR 7,55,000
Interest expense per month = INR 42000
We are calculating the interest coverage ratio for the quarter. Hence, we need to multiply the monthly interest payments by three to find the value of the quarterly expense.
So, interest expense for the quarter = 42000 X 3 = INR 1,26,000.
Now that we know both the quarterly findings for this quarter. Let us calculate the interest coverage ratio.
The formula for interest coverage ratio is,
Interest Coverage Ratio = Earnings before interest and tax / Interest expense.
So, for Makati Limited the interest coverage ratio is:
Interest coverage ratio = INR 7,55,000 / INR 1,26,000 = 5.99
Makati Limited has an interest coverage ratio of 5.99 times, which means that Makati Limited can pay its interest expense for this quarter 5.99 times with its quarterly earnings.
or,
It can also mean that the revenues for this quarter are enough to pay the interest expense for the next six quarters.
The ideal interest coverage ratio differs from industry to industry and company to company. However, an interest coverage ratio above 1 indicates that the company can pay its debt interest with the earnings of that period.
An interest coverage ratio above 1.5 is expected to be the minimum standard for every company. Investment experts prefer an interest coverage ratio above 2.
If a company is highly prone to fluctuation, then an interest coverage ratio above three is expected to be the minimum standard to gain investors’ trust.
Outstanding debt interest is like quicksand. The company has to borrow money to repay interest on already borrowed money, which increases the debt burden on the company.
Not being able to maintain your debt repayment is an alarming situation for any organisation. This is why having a safety net for paying debt is crucial for every company.
The interest coverage ratio efficiently provides insights into the company’s financial health. Using this ratio will give you a holistic picture of a company’s upcoming trajectory or current financial position.
Investors look at the past records of interest coverage ratios to assess the financial stability of a company. This assessment provides excellent information about the performance graph of a company, thereby helping the investor evaluate its current financial health accurately.
It can also be a metric of assessment for banks. Some banks use an interest coverage ratio with a low value as a medium to charge a high-interest rate on loans from such companies.
Apart from earnings before interest and tax (EBIT), other numerators are considered for calculating the interest coverage ratio. Two types of numerators are used instead of EBIT to calculate this ratio, and those numerators are:
Earnings before interest, taxes, depreciation and amortisation (EBITDA)
Earnings before interest and after taxes (EBIAT)
Sometimes, we use earnings before interest, taxes, depreciation and amortisation (EBITDA) instead of simply using earnings before interest and taxes (EBIT) to calculate the interest coverage ratio. We use this numerator because EBITDA will give a higher interest coverage ratio. Depreciation and amortisation are not a part of interest expenses.
They are also non-operating expenses and should not be included in calculating the interest coverage ratio.
If a company has depreciation and amortisation, then it is better to calculate the interest coverage ratio after deducting depreciation and amortisation along with interest and taxes from the company’s earnings to get a clear picture of the industry payment capabilities of the company.
Earnings before interest and after taxes (EBIAT) are used to calculate earnings before interest and tax (EBIT) during interest coverage ratio calculation because tax is a payable expense.
Hence, deducting taxes from earnings helps the investor get a clear picture of the coverage ratio and the actual payments of the company. This clarity will allow them to make wise and well-informed investment decisions.
Some commendable characteristics of the interest coverage ratio are as follows:
There are two sides to a coin. Similarly, like other financial metrics, the interest coverage ratio also has its fair share of demerits that the investors should be aware of before using it for their financial analysis.
The demerits of the interest coverage ratios are as follows:
Final thoughts
An interest coverage ratio is an essential financial tool for analysing the ability of a company to pay its interest on outstanding debt. However, it can be challenging to find a clear-cut method to explore a company through interest coverage ratio. This difficulty arises because the analysis of a company through interest coverage ratio is influenced by the risk-taking capability of a creditor or investor.
A bank might be more comfortable with an interest coverage ratio of a higher value if it is looking for companies with a high credit score. But if the bank is looking for companies with a low-interest coverage ratio, they must be willing to take the risk of incorporating a higher interest rate on loans that they give to that company.
The standardisation of interest coverage ratio remains the same. If it is less than one, the company is not earning enough to pay its interest on outstanding debt. Such companies are hazardous and are not entertained by funding institutions.
Similarly, if the interest coverage ratio is greater than 1, the company is earning enough to pay interest on its outstanding debt.
A company that is barely making it through and operating penny to penny tends to have an interest coverage ratio of 1.
As we know, the interest coverage ratio is a financial metric that helps us gauge the ability of a company to handle the interest payable on its outstanding debt.
The interest coverage ratio is a debt ratio that helps us understand a company's financial position.
The value of interest coverage ratio refers to the number of times a company can pay its interest with the earnings available for a specific period.
It can also be inferred as the number of coming years or quarters the company can pay its interest from the current earnings.
The interest coverage ratio is calculated by dividing earnings before interest and tax (EBIT) from interest payable on outstanding debt.
There are two variations available in the numerator.
One can use earnings before interest, tax, depreciation and amortisation (EBITDA) or earnings before interest and after tax (EBIAT), depending on the goal of their analysis. But, the common numerator happens to be earnings before interest and tax (EBIT).
The interest coverage ratio can also be calculated for different periods. Depending on their preference, an investor can determine the interest coverage ratio for a quarter, a year, or a half year.
If a company has an interest coverage ratio above one, it indicates that it can pay its interest with its earnings.
An interest coverage ratio of 1.5 would indicate a safe company because the company will have a cushion of earnings balance after paying the interest on outstanding debt.
However, to be in investors' good books, a company must have an interest coverage ratio of above two. But, companies from volatile industries must have an interest coverage ratio of 3.
An interest coverage ratio below one is alarming because it means that the company cannot pay interest on its outstanding that with the earnings generated.
An interest coverage ratio equal to one is also no good because it means that the company is badly making enough to complete its interest payments.
An interest coverage ratio of 1.5 is acceptable but not good because the company does not make enough to pay interest for another quarter or year.
Hence, if unforeseen circumstances arise or revenues plunge due to seasonal or cyclical factors, the company might fail to pay interest.
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