Interest coverage ratio measures a company’s ability to pay the interest on its outstanding debt. A high ratio means that the company will have no trouble paying the interest expense, while a low ratio indicates a potential default on the loan payments. Lenders and creditors use this ratio to determine if they would be willing to take the risk of funding the company’s operations.
Interest Coverage Ratio Formula
The calculation of the interest coverage ratio is straightforward. The formula for interest coverage is
Interest Coverage Ratio = ( Earnings Before Interest and Taxes / Interest Expense )
The EBIT and the Interest Expense are both measured within the measurement period.
Normally, an interest coverage ratio of 2.5 is considered to be adequate while a ratio of 1.5 or under should raise serious red flags. Also, if the historical trend of the interest coverage ratio is that of a decline, one should carefully look into the financials to understand where the decline comes from and the steps the management is taking to stem the decline.
If the interest coverage ratio falls under 1, the company essentially dips into its cash reserves to pay the interest on its debt, as the earnings are not sufficient to service the debt completely. If this situation is not quickly corrected, this could lead to a death spiral for the company.
How to Use the Interest Coverage Ratio?
Interest coverage ratio is a measure of solvency for the company. If a company does not maintain an ICR of 2.5 or better, the company may have trouble borrowing from the market any further. One should also keep in mind that a company may accrue interest expense throughout the term but not really pay it out during this term. In cases like this, an interest coverage ratio under 1 can easily be lived through until the next quarter.