What is Interest Coverage Ratio?
The interest coverage ratio is a financial metric that assesses a company’s ability to meet its interest obligations on its outstanding debt. It provides insight into the company’s ability to generate enough operating income to cover its interest expenses.
To calculate the interest coverage ratio, you can use the following formula:
Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense
- Earnings Before Interest and Taxes (EBIT): It represents a company’s operating income before deducting interest and taxes. It is sometimes referred to as operating profit.
- Interest Expense: The amount of interest paid or payable by the company on its outstanding debt over a specific period.
For example, if a company has an EBIT of $500,000 and an interest expense of $100,000, the calculation would be as follows:
Interest Coverage Ratio = $500,000 / $100,000 = 5
In this case, the interest coverage ratio is 5, indicating that the company’s operating income is sufficient to cover its interest expense 5 times over.
The interest coverage ratio is an important indicator of a company’s ability to service its debt obligations. A higher ratio indicates a greater ability to cover interest expenses and suggests a lower risk of default. Conversely, a lower ratio suggests a higher risk of default as the company’s operating income may not be enough to meet its interest obligations.