Interest Coverage Ratio – Meaning, Assumptions and Interpretation

The interest coverage ratio is a number that has a lot of importance for the creditors of the firm. This number tells them how safe their investments are and how likely they are to get back principal and interest on time.

Formula

Interest Coverage Ratio = EBIT / Interest

Meaning

The interest coverage ratio tells investors how many rupees they have made in profit, per rupee of interest that they owe to their shareholders. Thus if the interest coverage ratio is 3, then the firm has 3 rupees in profit for every 1 rupee in interest obligations. Thus profits will have to fall by more than 66% for the firm to register a loss.

Assumption

The standard assumption of no accounting manipulation in either of the two numbers involved (EBIT and Interest expenses in this case) is made while calculating the interest coverage ratio.

Interpretation

• Higher Ratio Means Solvent: The higher the interest coverage ratio of any firm, the more solvent it is. If an organization, under normal circumstances, earns way more than what its interest costs are, then it is financially secure. This is because earnings would have to take a real beating for the firm to default on its obligations. Hence, interest coverage ratio is of prime importance to lenders like banks and bond traders. Credit rating agencies also pay close attention to this number before they rate the company.

• Tolerance Depends On Variability: In industries where sales are very stable, such as utilities companies, a lower interest coverage ratio should suffice. This is because, these industries, by nature record stable revenues. Hence the sales and profits of the company are unlikely to witness wild fluctuation. This means that even in tough times the company will most probably be able to make good its interest obligations because its performance is not affected by the business cycle.

  On the other hand, companies with highly variable sales, like technology and apparel companies, need to have a high interest coverage ratio. These industries are prone to wild fluctuations is sales and investors want to ensure that their cash flow is not interrupted as a result. Hence they demand a higher interest coverage ratio before they give out their money.

• Ability To Take On More Credit: This is a corollary of the fact that high interest coverage ratio means the company is solvent. Lenders want to lend money to people who are solvent. This ensures that they get repaid on time and the risks of business are assumed by the owner. Thus, companies with high interest coverage ratios are more likely to get credit easily and on more favorable terms.