Interest Coverage Ratio

Interest Coverage Ratio

“I’m not that much of a risk taker. I just take situations that people perceive to be high risk, and I decide that they can be managed to low risk.” – Andrew Beal

What is the interest coverage ratio?

Measures the effectiveness of using of debt to finance a business.

How is the interest coverage ratio calculated?

Interest coverage ratio = EBIT / Interest Expense.  Earning Before Interest and Taxes (EBIT) equals net income plus interest and taxes; Interest Expense is the costs associated with borrowing funds. 

What does the interest coverage ratio mean to my business?  

A higher ratio is a positive indicator as the ratio measures the number of times a business’s earnings are available to pay its interest payments.  The lower ratio is more negative as there are less earnings available to cover interest payments.  It can also be considered a measure of risk as the higher the ratio the lower the risk of default and the lower the ratio the higher the risk of default.  

As with most financial ratios, trends are more telling than a single period’s ratio.  If over time a business’s interest coverage ratio is increasing, it is an indication that its debt is coming less of a burden and risk of default is lower.  The opposite is true of the ratio is declining. 

Finally, the cost of borrowing (interest rates) are generally impacted with this ratio.  The higher ratio generally equates to lower interest rates and lower ratio equates to higher interest rates.

Negatives to the interest coverage ratio:
Understanding the specifics of your business is critical.  Comparing this ratio to other business, even in the same industry, may not make sense.  For example, the steadiness of revenues would be an important factor in determining whether a low ratio is good or bad.  If revenues are constant, a low ratio may be acceptable.  If revenues are unpredictable, a higher ratio becomes a more important determinant of financial risk.