In this article, we will cover how to calculate interest coverage ratio. This includes the key definition, formula, example calculation, advantages and limitation as well as other areas which you should know.
Table of contents
- What is Interest Coverage Ratio?
- How to Calculate Interest Coverage Ratio?
- Interpretation and Analysis
- Important Consideration with Interest Coverage Ratio Calculations
- What Does the Interest Coverage Ratio Reveal?
- How to Improve the Interest Coverage Ratio
- Advantages of Using the Interest Coverage Ratio
- Limitations of the Interest Rate Coverage Ratio Analysis
Businesses seek an optimal balance for the gearing level. Basically, debt financing is cheaper than equity financing. The interest paid on the debt financing is tax deductible expense, and the debt is often backed by collateral which makes it a less risky financing option. However, collateral is not the only predetermining factor for finance facility approval. The lenders will also be interested in the ability of the business to repay the borrowed finance and pay the decided interest on time. Thus, they will look at the interest coverage ratio of a company. Lenders often analyze a business’s financial statements before deciding on the financing approval. Gearing ratios are an integral part of a business’s ability to repay loans and interest payment.
What is Interest Coverage Ratio?
The interest coverage ratio is also called as times interest earned ratio. It is one of the financial analysis techniques or tools that measure of the ability of a business to pay interest on the debts against its earnings. It offers an insight to the number of times a business is able to repay interest expenses from its earnings.
How to Calculate Interest Coverage Ratio?
We can calculate the interest coverage ratio or times interest earned ratio by dividing the earnings before interest and tax (EBIT) with interest expense. There are different ways the interest coverage ratio can be calculated and interpreted. The EBIT is taken from the Income statement and we can sometimes call operating income. The interest expenses would include all the financing costs for short-term and long-term loans.
In some case, we can calculate the interest coverage ratio by taking the earnings before interest, tax, depreciation and amortization (EBITDA).
Interest Coverage Ratio Formula
Below is the interest coverage ratio formula:
Interest Coverage Ratio = EBIT/Interest
Interest Coverage Ratio = EBITDA/Interest
Example and Calculation
Below is the extracted statement of profit or loss of ABC Co for the year ended 31 December 20X9:
|US$ m||US$ m||US$ m|
|Profit before interest and tax||30.2||27.7||26.3|
|Profit before tax||24.9||21.5||20.3|
|Income tax expense||7.8||6.7||6.3|
|Profit after tax for the period||17.1||14.8||14|
The interest coverage ratio for the average industry similar to ABC Co is 8 times.
Compute the interest coverage ratio of ABC Co.
In our calculation, we will use the profit before interest and tax as the basis. The interest coverage ratio can be calculated as per the table below:
|US$ m||US$ m||US$ m|
|Profit before Interest and Tax (A)||30.2||27.7||26.3|
|Interest Expense (B)||5.3||6.2||6|
|Interest Coverage Ratio (C = A/B)||5.7 times||4.5 times||4.4 times|
From the calculation above, the interest coverage ratio keep decreasing from 5.7 times in 20X6 to 4.5 times and 4.4 times for 20X7 and 20X8 respectively. This decreasing is because of the profit before interest and tax decrease from year to year.
In order to understand further, we should investigate why the EBIT has decreased over times like this.
When we compare the relevant industry average data with similar business, ABC Co has much lower interest coverage ratio than the industry which is at 8 times.
Interpretation and Analysis
The most important point to consider with gearing ratio analyses is to keep in mind that the figures taken from financial statements are historic. The past data cannot be used to determine the current actual position of the business. Also, the interest coverage ratio or any other ratio analysis alone cannot be interpreted with accuracy without comparisons. The ratio will provide an absolute figure, which cannot reveal anything unless compared with industry standards or the business historical performance. Mathematically, the interest coverage ratio must stay above 1.0. As the ratio below 1 would mean the denominator figure is larger than the numerator. In this case, a figure below 1.0 would mean the interest and financing costs exceed the operating profit.
Important Consideration with Interest Coverage Ratio Calculations
The interest coverage ratio portrays the picture of gearing level and ability to pay the financing cost of a business. Therefore, the lenders and creditors would interpret the ratio differently. As many businesses struggle with liquidity even though enjoy profitability, the measure of cash flow becomes important with interest cover ratio.
The numerator figure in the interest cover ratio is the important figure, as the financial costs would usually be known with a defined interest rate. As the lenders change the numerator, the interoperation slightly varies for the ratio. The interest rate coverage ratio can be calculated in different ways with different numerators as:
- PBIT or EBIT – Earnings before Tax and Interest
- PBITDA or EBITDA – Earnings before tax, interest, depreciation, and amortization
- PAT or EAT – Earnings after tax
The first numerator of EBIT is simply the operating profit of the business arrived at after deducting operating expenses from the revenue.
The second measure considers the importance of cash flow adjustments with depreciation and amortization costs. As depreciation and amortization are simply accounting adjustments and do not involve the cash outflow, therefore, it is a realistic approach to deduct the figures from the profits. The EBITDA figure would include better ratio as it would include the cash flow statement adjustments of depreciation and amortization.
Some lenders use the Earnings after tax figures. As they want to evaluate the business’s ability to pay interest after deducting all obligatory payments including taxes.
What Does the Interest Coverage Ratio Reveal?
In simplified terms it reveals the business’s ability to meet its financing costs. But the operating profits alone divided with interest expenses cannot reveal the whole picture. For example, does the interest coverage ratio for the business meet the industry standards? Or does it reduce over the time?
Other important points to consider with ratio analyses of gearing can include:
- A higher interest coverage ratio means stable cash flows for the business. At the same time it means the business hasn’t utilized the gearing options to the optimum level.
- A lower interest coverage ratio means the business cannot meet the financial costs with its operating profits. Hence the business would look for other short-term liquidity or financing options such as a revolving credit facility.
How to Improve the Interest Coverage Ratio
As it is a mathematical ratio, it can be altered or improved with both a change in the numerator figure and the denominator figure. Once the business decides on which figure to use for the interest coverage ratio, it can then take steps to improve the ratio.
- The interest coverage ratio will improve with optimal gearing levels. The business would need to find a balance in financing streams between equity and debt financing options.
- The operating income plays an integral part in interest rate coverage. Improving working capital with increased revenues and short accounts receivable days can help improve the operating profits.
- Debt financing options include fixed-interest and variable interest rate options. Choosing the better option with lower interest rates would improve the interest rate coverage ratio.
- A change in the gearing level of the business finance structure such as by settling a large debt facility can improve the interest coverage ratio.
- Cash flow adjustments for depreciation and amortization for long-term or non-current assets can also affect the interest coverage ratio.
Advantages of Using the Interest Coverage Ratio
Lenders and creditors concern about the borrower’s ability to repay the loans. Shareholders also keep a close eye on the business performance. Gearing ratios are key indicators of how well a business is managing its financing options.
- It’s a simple and easily understood ratio that can reveal the ability of a borrower to pay interest expenses
- A positive ratio or a ratio above 1.0 simply reveals that the business is earning more profits than its financing expenses
- The business can use the interest coverage ratio to convince lenders for financing facilities
- The interest coverage ratios can be used to compare the business gearing performance with industry standards
- It can help business in interest rate negotiations with lenders. As the lenders charge higher interest rates for the riskier finance facilities
Limitations of the Interest Rate Coverage Ratio Analysis
Financial performance ratios provide an overview of a business’s performance and overall stability. The gearing ratio also provides important insights on a business’s solvency. However, as with any other theoretical model, the interest coverage ratio also has some limitations:
- A standalone ratio figure cannot reveal the exact solvency picture of the business
- Ratio analyses are often performed with historical and past data that may change in real time
- There is no standardized method of calculating the interest coverage ratio
- The interest coverage ratio may change due unrelated factors affecting the operating profits in the short-term such as economic recessions
- The interest coverage ratio needs to be compared with industry standards of the same business size and market
The interest coverage ratio provides important information about a business’s gearing level. The ratio also offers insights about the business’s ability to meet the financial expenses against its operating profits. As the ratio includes cash out flows in the denominator it would be appropriate to use a cash flow adjusted figure like EBITDA as the numerator. The interest coverage ratio should be used to analyze the historic performance of the business with trends or change in the ratio over the years.