Interest Coverage Ratio

The interest coverage ratio is the ratio that measures the company ability’s to pay interest from the loan. It also is known as the “times interest earned” which the creditor and investor look to the company’s ability to pay for the interest.

Interest expense is the cost incurred by a business when borrowing money. This expense is typically recorded on the income statement as a line item. Interest expense can be either fixed or variable, and it is important for businesses to carefully consider the terms of any loan before borrowing. Fixed interest expense remains constant over the life of the loan, while variable interest expense can fluctuate depending on the loan balance. Businesses should also be aware of any prepayment penalties that may be assessed if they choose to repay their loan early. By understanding the terms of their loans, businesses can more effectively manage their interest expenses.

Failing to pay the interest on time can result in late fees and, in some cases, it can lead to legal action. If the business is unable to make payments on its loans, it could lead to default and foreclosure. When this happens, it has a huge impact on the company’s credit trustworthiness. Therefore, it is important for businesses to carefully consider their borrowing options and to make sure that they have the ability to repay both interest and principle.

This ratio shows how easily the company uses the profit to cover interest expenses. However, it is not the absolute science that varies from one industry to another. For example, the ratio of 2 is seen to be good for some companies, but it may be too low for other companies. For a stable business with a significant market share, it allows the company to access a low-interest rate from banks and creditors due to the low risk of default. On the other hand, the new start-up company will struggle to get a loan and it even faces a high-interest rate. Due to these issues, the interest coverage ratio will be misleading if we compare it across different industries.

Interest Coverage Ratio Formula

\[ Interest \ Coverage \ Ratio= {EBIT \over Interest \ Expense}\]

Interest Coverage Ratio Example

Based on the financial statement, Company A makes a total revenue of $ 1,000,000, COGS $ 300,000, and operating expenses of $ 200,000. There are some other expenses which around $ 100,000 and an interest expense of $ 150,000.

Description	Amount ($)
Revenue	1,000,000
Cost of Goods Sold	(300,000)
Operating Expense	(200,000)
Other Expenses	(100,000)
Profit Before Interest & Tax	400,000

Interest Coverage Ratio = 400,000 / 150,000 = 2.66 times

Why the interest coverage ratio is important?

It shows the company’s ability to pay interest expenses on the outstanding debt. A company’s interest coverage ratio is a financial metric used to assess the firm’s ability to make interest payments.
The bank and creditor use this ratio to access the risk they are going to face. The bank needs to evaluate the company’s ability to pay back the loan interest and principal. They are not willing to provide loans to a company that is not able to pay them back. It will become a risk for banks and creditors.
The auditor can use the ratio to access the company going concerned. Failing to pay interest is an indicator of a company’s liquidity. The company will be forced to liquidate when they are not able to pay back the interest and loan principal on the maturity date. It does not matter if the company is making a profit or not. They must have enough cash to pay for these obligations.
It shows the strength and weaknesses of the company’s financial health. The financial health of a company is important for a number of reasons. First, it provides an indication of the company’s overall profitability and solvency. Second, it can help to identify potential financial problems that may need to be addressed. Third, it can provide insight into the company’s ability to generate cash flow and meet its financial obligations. Finally, the financial health of a company can be used as a metric for assessing its overall performance. By monitoring the financial health of a company, investors and creditors can make informed decisions about whether or not to invest in or lend to the company.

Analysis

The lower rate represents the high chance of bankruptcy as the company does not have enough ability to pay for interest and debt. A low-interest coverage ratio indicates that a company may have difficulty making its interest payments, which could lead to default or bankruptcy. A lower ratio indicates that a company has fewer earnings available to pay its interest expenses, and is, therefore, more likely to default on its debt obligations.

The higher ratio shows that the company has enough ability to pay for interest expenses. The company even has enough ability to seek a new loan. This is because creditors view a high ratio as evidence that the company is capable of meeting its financial obligations. As a result, a high ratio is often seen as a sign of financial strength and stability.

Advantages of Interest Coverage Ratio

Advantage
Easy to calculate	The calculation of the interest coverage ratio is straightforward. The required information can be found on the financial statements.
Easy to Understand	It easy for normal people to understand even if they are not financing people. It shows the company’s ability to pay for interest expenses.
To seek for additional loan	Company can use this ratio to show the ability to pay for interest expenses. It can convince the creditor to give an additional loan. Good ratio can even use as the benchmark to negotiate with creditors.
Comparable	We can use this ratio to compare between company to another company. Investors can find a good company to invest in as it will have a good ratio.

Disadvantage of Interest Coverage Ratio

Disadvantages
Based on historical data	The ratio relies on past data which does not really reflect future performance. The company may have a good ratio, but we can’t guarantee that it will perform well in the future.
No specific guide to define good or bad	The ratio does not tell exactly how good or bad the company is. It will be another problem when the companies are in different industries.