## Interest Coverage Ratio (Formula, Examples) | Calculate Interest Coverage Ratio

hello everyone welcome to the channel of

Wallstreetmojo today we are going to discuss a topic on interest coverage

ratio most of the companies have borings long term as well as short term and they

have to pay interest on the same so the investors need to keep a check on the

fact that where the company will be able to pay the interest on timely basis so

for this a financial ratio named as interest coverage ratio is very useful

see as you can see from the chart the Sun has interest coverage ratio of close

enough to 186.42 in case of ford but the interest coverage ratio is close enough to 28.44 so seems to be that the Sun has a good prestige in the market because of higher coverage as

compared to what Ford is able to so that is what we are going to evaluate over

here see interest coverage ratio basically helps to determine how easy a

company can pay interest on its outstanding debt so interest coverage

ratio can be classified as a debt ratio because that gives us the idea a general

idea about the financial structure and the overall financial risk faced by the

company see interest coverage ratio can also be classified as a solvency ratio

because that helps to understand whether the organization is solvent and whether

there are any near threats pertaining to bankruptcy now what is interest coverage

ratio by one single version see interest coverage ratio is a ratio which helps to

decode whether the company will be able to pay interest on timely manner there was

this guy called mr. Benjamin raha he was the author of a very famous book name

called the intelligent investor and call the interest coverage ratio as a part of

a margin of safety and he explained the term by comparing it to the engineering

of a bridge see when the construction of a bridge the weight it can carry is declared as say close enough to 10000 pounds but while the actual maximum

weight limit which it is built for 30,000 pounds so the that extra 20,000

pound it represents what it represents the margin of safety so to accommodate

the unexpected situation basically this margin of safety is nothing but to

accommodate the unexpected situation or unexpected cases now in the same way

interest coverage ratio represents the marginal safety with regards to

organizations interest payment to a certain extent this ratio also helps to

measure the financial stability of a company or the hardships it can face on

account of its boring see equity and debt are the very two sources of the

funds for any company an interest is the cost of a debt for the organization

analyzing whether a company is in a position to pay this cost is very

important therefore this is a very critical ratio for a shareholder and the

lender of the company now interest coverage ratio formula this is very

important let’s learn what is interest coverage ratios formula interest

coverage ratio is calculated with a very simple formula let’s dig into this we

will write interest coverage ratio okay and when what is equal to sign saying

interest coverage ratio is earning before interesting tax that is called a

EBIT for the period earning before interest and tax for the period divided

by you will say the total interest total interest payable in the given period so

this is going to be your formula for interest coverage ratio earning before

interest and tax is your operating profit of the company so operating

revenue minus all the operating cost will give you the operating profit so

operating profit for the period divided by the total interest the formula is

trying to say that well what is the level of interest is getting covered up

in the operating profit of the company let’s dig into an example like let’s understand this formula better with the help of all example okay so I’ll cover

the next sheet let’s see that what we can make some

conclusion from this particular example see there is a revenue revenues coming out

from two particular things project advisory and consultancy fee that gives

us the total revenue there are a couple of expenses the total operating expense is

close enough to 111800 and in 2014 it’s 106300 this is the operating income A that is A-B and less any other expenses that will give us earning before interest and

tax that is EBIT which is important to us less the interest that gives us the

profit before tax and you deduct tax you get back so let’s now calculate the interest coverage ratio with the help of taking a

Ebit as a base so interest coverage ratio let’s calculate this one for the year so

just just keep it interest coverage ratio we have 2015 and 2014 so we don’t

need to under the enter the year before interest in taxes 19100 divided by the interest that is 9200 that is 9.79 is the coverage ratio and what was in 2014 so let’s

check that in EBIT divided by the interest so it was 10.22 coverage and in 2015 it drops down to 9.79 so the condition has not improved the condition has deteriorated that means

the profits are reducing in terms of the previous year compared to the previous

year and the interest as also has taken a rise so this is how you calculate the

interest coverage ratio now you could also calculate this is interest coverage

ratio with the help of EBIT I’ll just write over here EBIT now interest coverage ratio formula can also be used can also be

calculated with the help of EBITDA now what do you win by EBITDA very important element because in finance this word is really this particular thing is very important EBITDA that means earning before interest tax

depreciation and amortization so a slight variation of the above to add any non-cash expenses to EBIT any knows non-cash expenses to EBIT will

give us EBITDA and then calculate the interest coverage ratio so the formula

for the same is EBIT for the Period plus any non-cash expenses so I’ll just copy

over here I’ll say control V EBIT for the period you will just need to add any

non-cash expenses over here and that’s it / everything remains the same so this

is the interest coverage ratio for EBIT for EBIT and the below one is for EBITDA

for EBITDA so that is it now see basically the what exactly include

includes this non-cash expense non-cash expense is like depreciation or

amortization for most of the companies so to understand this formula first let

us understand I mean what do we mean by non-cash expenses see as the name itself

suggests this are the expenses incurred in the books of accounts but there is no

actual cash outflow on account of this expenses a very good example of this is

depreciation see depreciation measures the variant thereof of the fixed asset

on yearly basis but does not lead to any cash outflow so the logic behind adding

this non-cash expenses is to arrive at a figure which will be available for

payment of interest in a true sense and not just as for the book profit so if we

add this expenses the interest coverage ratio will definitely increase so taking

the above example we have let’s let’s calculate the interest coverage ratio

with the help of EBITDA so will say EBIT will have to add back any depreciation divided by we will have to divide by interest will put this

completely in a bracket once we do that the interest coverage ratio you can see

it has automatically increase it was 9.79 by increasing the depreciation it is quite logical that the amount will go up so in the

similar fashion you can do can just do ctrl R and C again over here

it has increased so if you want to copy any formula in a row wise you can you

can go for ctrl R and any column wise you can go for ctrl D so Financial

Analysts use either the first formula or the second formula depending upon first

means EBIT or second means EBITDA and the the the uses formula depending upon

what the fee is more appropriate to them and depending upon various other

criterias see interest coverage ratio I’ll give you of colgate using EBITDA method see let is not calculate interest coverage ratio of colgate in this particular example now what we’re going to do will be using EBITDA formula now Colgates interest coverage ratio is equal to EBITDA / interest expense okay will use the second formula now in in Colgate

the depreciation and amortization amortization expenses were not being

provided in the income statement and you can easily find those in the cash flow

operation section now also interest coverage ratio of Colgate very healthy

and it has maintain interest coverage ratio in excess of 100 X for the past

2 years old also in 22 2013 the net interest expense was negative the

interest expense and interest in Less the interest income hence the ratio was not calculated now let’s make an interpretation of this

interest coverage ratio see interest coverage ratio is a solvency check for

the organization in simple words the ratio measures the number of times the

interest can be paid with the given earning of the company therefore higher

the ratio better it is so a higher the ratio means that the organization has

sufficient buffer even after paying interest now in the above example of

message high earners limited like as we learn as the interest coverage ratio of

a approximately 10 for 2040 and this means that it had enough buffer to pay

the interest for 9 times over in about the actual interest payable so putting

it in other words one can say that lower the ratio more the burden on the

organization to pay the cost of debt now when the ratio tips to below 1.5 it

means a red alert for the company it indicates that it may be barely be able

to cover the interest expense anything below 1.5 means the

organization might not be able to pay the interest on borings now there are

very high chance of default in this case and it may also create a very negative

impact on the goodwill of the company as all the lenders will be very cautious

about the invested capital and any prospective lenders will shy away from

this opportunity also in case the company is unable to pay interest it may

end up borrowing more and they fall to debt trap I mean this generally worsens

the situation lead to a loop where the company keeps on boring to more to cover

its interest expense now what happens if the interest coverage ratio actually

falls below 1 in this case it means that you know the company is not generating

enough revenue which is why the totaling these people is more than the earning

before interesting tax this is a strong indicator of a default below 1 so this

often leads to a risk of falling into bankruptcy I know in most of the cases

the main interest coverage ratio should be around 2.523 and this much is enough to not trigger a red flag however there can be many instances where a

company has to maintain a higher ratio such as a strong internal policy but the

management has been dated to maintain a higher ratio and there may also be

contractual requirement of various borrower was a company to maintain a

high ratio also different industry may have a different level of acceptability

of interest coverage ratio generally industries where the sales are stable

such as like basic utilities can do with a lower interest coverage ratio this is

because they have a comparatively steady EBIT and their interest can easily be covered in case of difficult times whereas industries which tend to have

fluctuating sales such as like technology should have a comparatively

higher interest coverage ratio here the EBIT will fluctuate here the EBIT will structure in accordance with the sales as the best way to manage the cash

flow is by keeping keep buffer cash by maintaining a higher ratio what is the

limitation of in the interest coverage ratio see like every other financial

ratio interest coverage ratio has its own set of limitation as well some of

the limitations are as for unlikely looking at the ratio for a given period

may not the true picture of the company’s

position as there can be seasonal factors which can hide the stock the

ratio and for example in a given in the in the given period the company has

exceptional revenue on account of new product launch which is already banned

by the government going forward so looking at theme just coverage ratio

only in this period may give the impression that company is doing well

however if the ratio is compared to the next period it might show a totally different picture so an important shortcoming of this ratio is that the

ratio of this is not consider the effect of the tax expense to the organization

tax expenses deducted after earning before interest in tax and that’s affects

the cash flow of the organization and it can be deducted from the numerator of

the ratio to arrive it better see consistency in accounting policies and

principle followed while preparing financial statement can also be very

critical factor in analyzing the past trends and comparing industry peers

while calculating the interest coverage ratio best way of using interest

interest coverage ratio is to use financial ratio is to use an umbrella of

the ratios at given point of time many other financial ratio ratio such as cash

ratio quick ratio current ratio debt equity ratio and p/e ratio etc should be

used along with the interest coverage ratio for effective analysis of the

financial statement this helps to maximize the advantage of this ratio and

at the same time minimize their limitation thank you