Understanding Interest Coverage Ratio

Interest Coverage Ratio measures how well a company can pay its interest expenses, which are concerned with outstanding debts. It is computed by dividing EBIT (Earnings Before Interest and Tax) by Interest Expenses. This ratio is expressed as 'x' number of times a company can meet its interest expenses. This metric is commonly used by Lenders, Investors, and Creditors to analyze the risk before lending capital to a company. Interest Coverage Ratio is also popularly known as the 'Times Interest Earned Ratio'.

The formula to derive Interest Coverage Ratio



EBIT - Earnings Before Interest and Tax (EBIT) indicates the company's profitability before paying interest and tax. EBIT is also known as operating Profits or Net Income before interest and tax. And it is found in the Income statement of the company.

Interest Expenses - it is interest that the company has to pay on its borrowing like debts, bonds, credits, etc., These are non-operating expenses that are recorded in the company's Income Statement.

Example of Interest Coverage Ratio: For the financial year, Cummins India Limited reported EBIT as Rs. 842.59Cr., and Interest Expenses as Rs. 16.76 Cr.
The value as per the formula (EBIT / Interest Expenses) is calculated as (842.59 / 16.76) = 50.27.

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Key Highlights

The interest coverage ratio is computed by dividing EBIT (Earnings Before Interest and Tax) by Interest Expenses.

This ratio is helpful to measure the company's financial stability, and it even represents marginal safety concerns with a company's interest payments.

The interest coverage ratio helps to analyze the company's solvency position and whether it can pay its interest payments or not.

A high interest coverage ratio indicates that the company can meet its interest expenses by EBIT (Earnings Before Interest and Tax).

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While looking at the Interest Coverage Ratio, the following points should also take into consideration:

A high Interest Coverage Ratio is considered good. It indicates that the company is financially healthy and capable of meeting its interest expenses and debts.

A low Interest Coverage ratio below one indicates that the company's operating profit or EBIT is insufficient to pay its debt obligations.

This ratio is helpful to measure the company's financial stability, and it even represents marginal safety concerns with a company's interest payments.

Generally, the ideal interest coverage ratio is 1. It shows that the company can meet its interest expenses one time in a given financial period. But if the company wants more borrowings in the future, it will be hard to meet its interest expenses.

A company with a high interest coverage ratio above three is considered excellent. It indicates that the company is financially strong and has more than sufficient operating profits to meet its interest expenses. If the company has a high ratio and wants more debt borrowings for growth and expansion, it will be easy to take more borrowings.

Interest coverage ratio considered EBIT over net profit. Net profit is the value after deduction of all expenses. And if we take net income instead of EBIT, then the interest expenses will count twice, and it will not give an accurate figure. And EBIT is net income before interest and taxes. So it gives a more accurate value.

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How to use the Interest Coverage Ratio effectively

Investors should look higher ratio at least above 1 or 1.5. It indicates that the company has enough or more than enough operating profits to pay off its interest expenses.

The interest coverage ratio helps to analyze the company's solvency position and whether it can pay its interest payments or not.

While analyzing the company investors, should check its historical data to understand past performance. If the interest coverage ratio is increasing over a period is a good sign. It indicates that the company is getting more efficient in paying its interest expenses. And if the interest coverage ratio is decreasing over the period and it is below three, it indicates that the company is getting risky.

The Interest Coverage ratio differs from industry to industry. For better analysis, compare the company with its industry peers.

For better analysis of companies, check other financial metrics related to Interest Coverage Ratio like Debt to Equity Ratio, Dividend Coverage Ratio, Current Ratio, etc.,

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