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