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Interest Coverage Ratio
What is interest coverage ratio? Interest coverage ratio is a financial ratio that is used to determine a company’s ability to pay interests on outstanding debt or liabilities. It measures the number of times a company can easily make the debt payment with its earnings. For investor and stockholder, interest coverage ratio provides a safety measure. Investors can find out at what level of earning the company has potential risk of defaulting or payments.
Interest coverage ratio is calculated by dividing EBIT (Earnings before interest and taxes) by interest expense. EBIT generally comes off income statement. Use the Income Statement calculator within this site or the above calculator to determine EBIT.
Importance
As a general rule of thumb, an interest rate under 1 shows that the company’s performance is barely adequate to pay for its interest expense. If the company’s performance doesn’t improve, there is a high chance of defaulting. On the other spectrum, if the company has a very low Interest coverage ratio, this too can indicate that company might not be leveraged well. To find a good balance we need to compare the industry average.
Use the Interest coverage calculator above to calculate. Below is Example of interest coverage ratio.
Example:
A company has revenue of $1 Million. It has cost of goods sold $200,000 and operating expense of $300,000. The company’s interest expense for this year is $150,000. What is the company’s Interest Coverage ratio and explain what it means?
EBIT = Sales – cost of goods sold – operation expenses.
EBIT = $1,000,000 - $200,000 - $300,000
EBIT = $500,000
Interest Expense = $150,000
Interest Coverage Ratio = $500,000/$150,000 = 3.33
The company has a high interest coverage ratio. This means that company has to earn three times less before it can default on its loan payment.
Suggested Calculators:
Accounting Equation
Return on Assets (ROA)
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