What is the importance of Interest Coverage Ratio?

16 Sep 2019 Read 84 Views

A layman can end up losing his hard earned money if he doesn’t take his investment decision wisely and picks a stock randomly just by looking at its numbers flashing on the real time stock screen.

To get the real picture about the company’s ability to meet its financial obligation, coverage ratios play a crucial role.

One of the significant and most crucial liquidity ratios is the Interest Coverage Ratio, which indicates the level of a company's ability to afford the interest that is to be paid by the company for raising debt. It does not measure the ability to make principal payments on the debt; instead it depicts how much the company can afford to pay the interests on the debt promptly.

An investor shall be interested in the interest coverage ratio of a company as it determines whether the company can make timely payments without having to compromise on its day-to-day operations and profits that it is making. It also determines whether it is risky or profitable to invest in the company.

Formula & Example

Interest Coverage Ratio = Earnings before Interest & Tax (EBIT)/ Interest Expense

Let us consider the example of company ABC ltd, with its income statement as follows:

Income Statement of ABC ltd.

Sales Revenue

11,00,000

Cost of Goods Sold

(1,00,000)

Gross Profit

10,00,000

Salaries

(40,000)

Rent

(40,000)

Depreciation

(20,000)

Total Expenses

(1,00,000)

Operating Profit (EBIT)

9,00,000

Interest Expenses

3,00,000

Earnings before Tax (EBT)

6,00,000

Tax Expenses

1,20,000

Net Income

4,80,000

Here;

  • Earnings Before Interest & Tax/Operating Profit = Rs. 9,00,000
  • Interest Expenses = Rs. 3,00,000
  • Interest Coverage Ratio

= EBIT/Interest Expenses

= 9,00,000/3,00,000

= 3:1

Hence, the company ABC ltd has an interest coverage ratio of 3 which indicates that it has sufficient funds to pay off the interests in timely manner.

Factors Affecting Interest Coverage Ratio

Some of the significant factors affecting the ratio mentioned above are:

  • Gross Profit: The higher the total profit of the company, the higher will be the operating profit, ceteris paribus. A higher operating profit will result in a higher interest coverage ratio.
  • Operating Expenses: Lower the operating expenses, higher will be the operating profit, ceteris paribus, hence resulting in a higher interest coverage ratio.
  • Interest Expenses: Lower the interest expenses of the company, lower will be the denominator of the interest coverage ratio. This will indicate that the company has higher affordability of the interest expenses, hence resulting in a higher interest coverage ratio.
  • Earnings before Interest & After Tax (EBIAT): This is a variation that can be used by some companies in place of EBIT. This will show a clearer picture of the company’s expenses before paying off the interest expenses as taxes play a vital role in a company’s financial position. However, this will lower the interest coverage ratio.
  • Earnings before Interest, Tax, Depreciation & Amortization (EBITDA): This is another variation that can be used in place of EBIT.

Interpretation & Thumb Rule/Norms

Some of the conclusions that can be inferred through analyzing the interest coverage ratio of the companies are:

  • Solvency: Higher the interest coverage ratio, more the company is solvent. It indicates that a lower portion of the company’s operating profit is dedicated to paying off its interest expenses which in turn means that the net income is more.
     
  • Credibility: Higher interest coverage ratio means that the company is more solvent. High solvency implies that the company will be able to pay off the interests without any crunch. This increases the ability of the company to take on more credit. Lenders and creditors will believe more in lending money to the company who will be able to pay the interests promptly.
     
  • A landmark for Small Companies: For a small company, higher the interest coverage ratio the better it is. Sometimes the interest coverage ratio may even cross the mark of 5:1. This will indicate that although the company is operating on a small scale, it is making profits high enough to pay off the interest expenses and is not going towards bankruptcy.
     
  • Interpretation for Large Companies: For a large company, an interest coverage ratio of 2 to 2.5 may suffice. This is because the company is operating on a massive scale due to which it has to take more and more credit which in turn means that it has to pay off more and more interest expenses.
     
  • Stability in Sales Revenue: If the company is operating in an industry where sales are relatively stable (such as utility industry), the company can still stay solvent with a lower interest coverage ratio since the minimum revenue that the company will earn will be almost assured.

However, if the company is operating in an industry where the sales are relatively variable (such as technology industry), the company needs to have a very high-interest coverage ratio so that it can pay off interests in a timely manner, even when the sales revenue are low.

Conclusion

The interpretations of the interest coverage ratio are dependent upon the industry or sector in which the company is operating. However, it can be safely surmised that an interest coverage ratio which goes below the mark of 1 can be dangerous for the company. Over some time, if such an interest coverage ratio is not improved, it may even lead to bankruptcy for the company.

About the Author: Ratan Deep Singh | 54 Posts

Ratan is a Biotechnology graduate and a former print-media Journalist, who specialized in marketing to take up Brand Communication. He’s a grammar Nazi & big-time foodie who appreciates creativity and often tries his hand in creative poetic writing.

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