Interest coverage ratio, or interest cover, 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 cover 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.
Also see: Debt Ratio
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.
Debt Spiral – What Happens if the Company Can’t Cover its Interest
A company’s inability to cover its interest payments may result in several possible unfavorable outcomes. Many dept covenants require the company to maintain a certain minimum level of interest coverage. When the company breaches this covenant, the lenders may accelerate debt and principal payments, causing a bad situation to become worse. In cases like this, the company has 3 options:
- Default on the debt and possibly head towards a bankruptcy process,
- Negotiate to amend debt terms and covenants and get some flexibility to come back into compliance, or,
- Re-finance debt
If the company chooses to re-finance its debt, it is likely that it can get better payment terms, but the weak financial condition will result in a worsened credit quality and higher interest rates. Borrowing at more expensive rates to payback debt may buy time, but unless the business improves significantly, the company will not be able to support the larger interest payments. This is the debt spiral that will eventually lead the company towards a more permanent fix – possibly bankruptcy.
Invest better with these key investment ratios