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The interest coverage ratio is a measurement of how well a company can cover the interest payments on its debt. It compares a companyâs earnings before interest and taxes (EBIT) and its interest expense.
A higher interest coverage ratio signals that a company is well positioned to pay off its interest expense. A lower interest coverage ratio means that a company is not as well positioned.
EBIT is used because this is the stockpile from which a company would pay its interest expense from.
To calculate the interest coverage ratio, use the following formula:
The interest coverage ratio looks at whether a company can pay off its interest expenses. If the ratio is low, this could mean that the company may have trouble paying off interest expenses, and on time.
If a company is unable to make its interest payments to its creditors on time, its ability to get more credit in the future, such as additional loans, may be hurt. When it is able to obtain loans, it may need to pay a higher interest rate, increasing its expenses and decreasing its profits.
In the extreme case, if a company is unable to pay its interest expenses for a long time, the company may end up in bankruptcy.
A âgoodâ interest coverage ratio varies across industries and companies. For example, an interest coverage ratio of 2 is considered good for utility companies.
Generally, lower interest coverage ratios are accepted in stable industries where earnings are more predictable. In volatile industries where earnings fluctuate, higher interest coverage ratios are wanted.
If a company has no debt, then the interest coverage ratio is meaningful, because the company has no interest expenses.
The interest coverage ratio is calculated for a specified time period, such as a quarter or a year. The formula to calculate the interest coverage ratio is:
For a public company, both EBIT and interest expense can generally be found on the income statement, also known as the profit and loss account.
If a company does not have a line for EBIT, it usually will have one for earnings before taxes. You can calculate EBIT by adding back interest expense to earnings before taxes to get EBIT.
Typically an interest coverage ratio of 5 or higher is financially sound. An interest coverage ratio of 1.5 to 2 or less is common among financially unhealthy companies. The US Federal Reserve analyzed interest coverage ratios across industries from 1970 to 2017 and found that the average interest coverage ratio was around 3.7.