The interest coverage ratio is one of the numerous ratios that interested individuals can use to gauge a business’s financial position. To be exact, it is used to examine how well a business can support the financial burden created by its outstanding debt, which can be critical should it run into financial problems in the future.
How Is the Interest Coverage Ratio Calculated?
In short, the interest coverage ratio is calculated as the business’s EBIT in a particular period of time divided by that same business’s interest expenses in that same period. For those who are unfamiliar with the term, EBIT stands for Earnings Before Interest and Taxes, which is exactly what it sounds like. Some people might be more familiar with EBIT as either operating earnings, operating profit, or even profit before interest and taxes, but whatever it is called, it can be calculated as revenues minus both operating expenses and non-operating expenses with the exceptions of interest and taxes. As a result, there are a lot of people who might be familiar with EBIT as a figure situated towards the end of the income statement, seeing as how it is separated from the final change in the period by no more than a couple of lines.
Meanwhile, interest expense is exactly what it sounds like, which is to say, the interest payable on the sums of money that the business has borrowed. Sometimes, calculating the interest expense should be a simple and straightforward matter. However, those are cases when calculating the interest expense can be somewhat more complicated because of the Matching Principle, meaning that even if the business isn’t expected to make a payment, it might still be accruing interest on an outstanding debt.
What Does the Interest Coverage Ratio Mean?
As stated, the interest coverage ratio is meant to examine how well a business can hold up under the financial burden created by its outstanding debt. To be exact, it looks at the number of times that its earnings can cover the interest that it has to pay on its debt. Generally speaking, a higher interest coverage ratio is better because it means that a business is more capable of supporting the financial strain. In contrast, a interest coverage ratio of 1.5 or less is cause for serious concern because it suggests that the business is in shakier position than it should be, so much so that it might fall should it encounter some kind of problem that either lowers its revenues or raises its expenses by a significant amount in the near future. Likewise, how an interest coverage ratio has changed over time can prove useful to interested individuals as well. For example, an interest coverage ratio that is rising suggests that the business is becoming more and more capable of supporting the financial strain of its outstanding debt. In contrast, an interest coverage ratio that is falling is cause for serious concern because it suggests the opposite.
With that said, it is important to note that the interest coverage ratio cannot provide interested individuals with the full details about a particular business unless they examine other ratios as well as other measurements for the full picture. For example, a falling interest coverage ratio doesn’t actually provide interested individuals with enough information to tell them why it is happening. It could be that the business’s revenues have been falling, but it could be that the business has taken on more debt for the purpose of fueling planned expansion that will see its revenues rise in the future. Simply put, the interest coverage ratio isn’t any more informative than any other ratio or measurement when examined on its own, which is why interested individuals should never make the mistake of being consumed by it.
For that matter, it should be mentioned that interested individuals should always consider the value of a ratio or measurement from their perspective rather than that of a general observer. In short, there are cases when someone might actually want to see a lower interest coverage ratio on the part of a business. After all, not everyone is an potential investor. Instead, some are potential lenders, who might be interested in a lower interest coverage ratio because they want to be able to charge a higher interest rate on their loans.