Interest Coverage ratio is a financial ratio that measures the ability of a company to pays its interest payments on its outstanding debt. In other words, its a measurement of how easy a company can pay its interest on its debts from its earnings. The interest coverage ratio us usually used by investors, lenders and creditors to determinate the riskiness of a capital invested in a company. The interest coverage ratio measures the number of times a company can make interest payments on its debt from its earnings (before interest and taxes or EBIT). It is important to notice that the interest coverage ratio does not take into account the ability of a company to make the actual principle payment on its debt and its is focusing only on the interest payment.
The interest coverage ratio can be calculated by dividing a company earnings before interest and taxes for a given period by the company interest payments obligations for the same period of time. The formula fo interest Coverage ratio is:
Interest coverage ratio = EBIT / Interest expenses
Where EBIT is earnings before interest and taxes or the company’s operating profit. Interest expense represents the interest payable (for the given period) on any borrowings such as bonds, loans, lines of credit, etc.
When it comes to company ability it pays its interest payments, the Interest coverage ratio is measurement of margin of safety. The lower the interest coverage ratio of a company is the more the company is burdened by debt expenses. In the same analogy if a interest coverage ratio is declining it might be an indication that the company might not be able to meet its debt expenses obligations in the feature. By following the trends of interest coverage ratio of a company an investor can determinate the short-term financial health of a company and get a better picture of its stability.
Generally a higher interest coverage ratio indicates stronger financial health of a company. When a company interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses might be questionable. Many investors and analysts prefer to see an Interest coverage ratio of at least 3.0 or higher. Having a ICR above 1.5 is generally considered as bare minimum. Having an interest coverage ratio below 1 means that the company is not generating sufficient revenues to satisfy its interest expenses.