Interest coverage ratio is used to measure a company’s ability to pay off interest payments on debt (from its income before interest and taxes). In other words, the ratio explains that is the company able to pay off interest expense on debt. The formula to calculate the interest coverage ratio is:
= EBIT / Interest Expense
EBIT = Earnings before Interest and Taxes,
these values can easily be taken from particular company’s financial statements.
A Hypothetical Example
Suppose, during the year, a company pays interest expense of $340 and its earnings before interest and tax are $1000. Calculate the interest coverage ratio.
The interest coverage ratio = $1000 / $340 = 2.94 times
This means that the company is able to pay its interest expense of $340, 2.94 times from its earnings before interest and taxes of $1000.
If the ratio is below 1, it means that the company is not generating enough income to pay its interest expenses, this type of company is highly risky and it would not get investment easily.
If the computation of the ratio is equal to 1, it means that the company can pay interest payments but it can not afford its principle payments.
The ratio will be considered favorable if it is greater than 1, means that the company is making enough income to pay interest expense and extra income left over to pay principle expenses.