Interest Coverage Ratio
Interest Coverage Ratio
The Interest Coverage Ratio is the last of our Leverage Ratios . Also referred to as the “times interest earned” ratio, this ratio measures how easily your company can pay the interest due on your outstanding debts, and is therefore a useful measure of solvency.
Interest Coverage Ratio Formula:
The Interest Coverage Ratio = EBIT / Interest Expense
EBIT: This acronym stands for Earnings Before Interest and Taxes.
Interest expense: The amount of money a business owes in interest (per month) on its current loans. Interest expense is located on a company’s income statement.
Income statement: A core financial statement that reports a company’s revenue and expenses over a set period of time.
What can the interest coverage ratio tell me about my business?
Fundamentally, the interest coverage ratio tells you how many times over your earnings can cover your interest expenses. It measures the coverage for a specific period of time, giving business owners and investors a good snapshot of short-term liquidity.
A higher interest coverage ratio is better, because it indicates you have a certain margin of safety when paying off debt interest. An interest coverage ratio below 1 means you are not currently earning enough money to pay off your interest expense, which is an alarming sign of impending financial trouble or even bankruptcy.
The interest coverage ratio is an important metric for lenders, investors, and creditors as well. The ratio is often employed to evaluate whether or not a company is a current financial risk, and whether or not they are a safe recipient for future loans.
Generally, an interest coverage ratio below 1.5 is seen as a lending risk.
But like any financial snapshot of a business, the interest coverage ratio only tells you the financial position of your business at a single point in time. Keep a close eye on where your interest coverage ratio is trending in order to determine whether or not your debt interest is increasing or shrinking relative to your earnings.
Interest coverage ratios also vary widely by industry, business model, and predictability of revenue. When determining what a healthy interest coverage ratio might be for your business, only compare yourself to those companies within your same industry, with similar business size and structure.