As an investor, you have a number of things to consider prior to investing your money. Some of the many factors you should look into are risk tolerance, inflation rate, dollar cost averaging, market conditions, stocks performance, tax rates, etc. You do not just put your cash into stocks or bonds without doing relative homework. Wise investors take ample time to assess the amount of risks and returns on investment by evaluating certain aspects including but not limited to economic risks, political risks, interest and currency risks, and financial health and stability of the company. As for the financial stability of the company, a technical analysis using interest coverage can significantly help you in deciding whether it is right to put your money into a particular enterprise.
Interest coverage also referred to as interest coverage ratio or time interest earned is used as a measure to indicate a firm's ability to meet its interest requirements on outstanding debts. Investors use this gauge when deciding to invest their money in a certain business. The interest coverage ratio suggests whether or not an enterprise is a good credit risk. It signifies the number of times interest is covered by earnings to settle the interest cost. Investors are more assured to put in their money on a firm that can consistently pay its interest cost because it is more likely to survive if income should decline unpredictably. By evaluating the company's earnings before interest and taxes (EBIT) and its interest due, you can tell whether it is at risk of falling behind on its interest payments. This is the accounting tool employed by investors or lenders to recognize if a firm is capable of paying off loans and if it has the ability to grow.
Determining the interest coverage is merely comparing the company's assets or gross profits, and liabilities or expenses. To get the interest coverage ratio, the earnings before interest and taxes or the company's operating income of a defined period which is part of the cost of running business is divided by its interest cost of the same period. The ratio will tell you how many times the firm can settle its interest expense on a pre-tax basis. If a firm's interest coverage ratio is lower than 1.5, it is struggling to meet its interest requirements. It is a sign that the business is not earning adequate profits to settle its interest charges. It needs to borrow funds to pay its debt obligations otherwise it could go bankrupt. The higher the interest coverage ratio, the higher the likelihood that the firm can pay its interest obligations hence it is attractive to lenders or investors.
While interest coverage ratio is a useful metric gauge of a firm's financial health, it is worth noting that it only gives you a picture of what transpired in the past. Therefore it should not be used as the only test of an enterprise's financial stability. Knowing how to distinguish current books of the firm and using other tools for measuring financial stability and reliability are highly critical.