Financial Ratios indicates company’s performance and health, here we will discuss a ratio that lenders and investors find useful and provides debt and profitability – Interest Coverage Ratio.
What is Interest Coverage Ratio?
The Interest Coverage Ratio is a way to measure your company’s ability to pay off the interest owed on any outstanding debt carried. Debt is unavoidable when you’re starting up a business, but debt itself is not bad thing. It is a measure of how many times over your company could theoretically pay off whatever interest you owe using your available earnings at the time the ratio is calculated.
How is Interest Coverage Ratio Calculated?
Calculation of Interest Coverage Ratio is straight forward:
Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense
Interest Expense comes from Non-Operating expenses. There are couple of variations for numerator, 1) Earnings Before Interest and Taxes (EBIT)where it is calculated subtracting operating expense [without Depreciation and Amortization] from operating revenue. 2) Earnings Before Interest and After Taxes (EBIAT), where it is calculated subtracting operating expense [without Depreciation and Amortization] from operating revenue and Taxes. 3) Earnings Before Interest, Taxes, Depreciation, Amortization (EBITDA).
Using either 1 or 2 numerator variation you will get lower or more conservative Interest Coverage Ratio and using 3 you will be get higher and more liberal Interest Coverage Ratio.
What is the Ideal Interest Coverage Ratio?
There are some general assumptions lenders and investors are looking for, you don’t want this ratio to be lower than 1.5. There are exceptions based on the industry you’re in. A savvy investor or lender will be looking at the interest coverage ratio over a period of time rather than one period. Higher is your interest coverage ratio, the better. If the ratio slips below 1.0, this raises a red flag that you are seriously risking dipping into your cash reserves to cover your interest payments.