Interest Coverage Ratio is the estimation on how many times a company can pay its interest payment obligations. This is important to determine because by doing so, you can save a company from a future bankruptcy or saving the lender institutions like banks for unpaid dues. This is helpful for a person in determining how many times they can pay interest on any of their financial obligations like mortgages, loans, credit cards and many others. This will also benefit the bondholders and stockholders in estimating their probability of loss to where they will invest their money. By knowing the coverage ratio, they will be able to sense how far a company can go before defaulting, and they will have an idea on the picture of the financial status of a chosen business. Interest Coverage Ratio may be determined by just simply following this formula: EBIT (Earnings before Interest and Taxes/Expense Taxes = Interest Coverage Ratio.
To understand the Interest Coverage Ratio, you need to understand results for the formula given above:
- Less than 1.0 result. If the result of the ratio is less than 1 percent, this means that the company is having difficulty in paying its interest obligations. The cost coverage of the financials of a company is not sufficient in paying interest over the said time frame. This would be an advantage and disadvantage. Advantageous in the sense that you are in hold of your finances but disadvantageous in terms of borrowing and growing business. Basic information from the company like net income, interest expense and taxes are crucial in reading results in the formula of the interest coverage ratio. Capital Interest, Interest Cost and Interest Stock may be added to EBIT (Earnings before Interest and Taxes) formulation.
- Average result. More than 1.0 result can signify that the company can meet its interest obligations. This is a safe result for persons who wish to invest their money in stocks or any income generating companies. Target financial increases would most probably be achieved. Lenders may also allow companies to open for loans since the financial stability is included in the company’s cash coverage over a period of time.
- Too high. Results that are too high signify that the company is playing “too safe”. It neglects opportunities to magnify earnings through leverage. The definition of leverage is something associated in usage of resources. This resource does not necessarily mean money. When you come across in this result, investing would not be advisable since the cash flow, etc. is most probably not expanding.
Basic knowledge on Interest Coverage Ratio is an advantage for anyone who wants to engage in borrowing, lending or even in investing in business. This would be how to have an idea whether or not you will pursue any business engagements. Just take note that the coverage ratio just covers short-term minimal results. This is because in this formula, the current income and current expense are involved, which we know will change over a period of time.