Interest Coverage Ratio
The interest coverage ratio is a measure of the number of times a company could make the interest payments on its debt with its earnings before interest and taxes, also known as EBIT. The lower the interest coverage ratio, the higher the company's debt burden and the greater the possibility of bankruptcy or default.
Interest coverage is the equivalent of a person taking the combined interest expense from their mortgage, credit cards, auto and education loans, and calculating the number of times they can pay it with their annual pre-tax income. For bond holders, the interest coverage ratio is supposed to act as a safety gauge. It gives you a sense of how far a company’s earnings can fall before it will start defaulting on its bond payments. For stockholders, the interest coverage ratio is important because it gives a clear picture of the short-term financial health of a business.
To calculate the interest coverage ratio, divide EBIT (earnings before interest and taxes) by the total interest expense.
EBIT (earnings before interest and taxes) ÷ Interest Expense = Interest Coverage Ratio
General Guidelines for the Interest Coverage Ratio
As a general rule of thumb, investors should not own a stock that has an interest coverage ratio under 1.5. An interest coverage ratio below 1.0 indicates the business is having difficulties generating the cash necessary to pay its interest obligations. The history and consistency of earnings is tremendously important. The more consistent a company’s earnings, the lower the interest coverage ratio can be.
EBIT has its short comings, though, because companies do pay taxes, therefore it is misleading to act as if they didn’t. A wise and conservative investor would simply take the company’s earnings before interest and divide it by the interest expense. This would provide a more accurate picture of safety, even if it is more rigid than absolutely necessary.
