EBITDA-to-Interest Coverage Ratio: Definition and Calculation

Its formula, EBIT divided by interest expense, reveals whether a firm can comfortably service its debt or face potential financial risk. The interest coverage ratio is an important metric that depicts how a company manages its debts. However, if the ratio is low, you must check whether the company is profitable enough to service its debts. Moreover, you should also check the overall debt position, i.e., whether the company has availed of very high debts or not. The interest coverage ratio can be calculated using two main inputs – the earnings before interest and tax and the interest payable on debt. The ratio is calculated for a specific time period, usually a financial year, and is expressed in an absolute number.

Plus, it may discourage potential investors or creditors because it reveals a higher level of risk. However, it’s also possible that a company with a low interest coverage ratio is in a high-growth phase and is using borrowed money to fuel expansion, resulting in temporarily depressed earnings. The interest coverage ratio can be calculated by dividing a company’s earnings before interest and taxes by its interest expense. To calculate interest coverage ratio, you can divide a company’s earnings before interest and taxes (EBIT) by its interest expense. The resulting ratio may indicate the number of times the company’s earnings can cover its interest payments. Are you curious about the financial health of companies and their ability to manage their debt obligations?

Meaning of interest coverage ratio

The interest coverage ratio is not designed to account for variations in interest costs. When a company’s debt structure has different interest rates, it might render the ratio less accurate. For instance, consider a company that has a combination of low-interest short-term debt and high-interest long-term debt. The interest coverage ratio would yield a higher result if the company has a larger proportion of its debt in low-interest, short-term liabilities. This does not necessarily mean the company is in a more favorable or safer financial position.

The interest coverage ratio is an indispensable tool used by businesses, investors, and creditors alike to evaluate an entity’s ability to cover its interest expense on outstanding debt.
Rather, it could be a mere reflection of the company’s debt structure, which can change over time and therefore could fail to provide an accurate picture of solvency.
An interest coverage ratio of 1.5 could be seen as the minimum acceptable threshold, but analysts and investors might prefer a ratio of two or higher.
Always compare ICR among similar companies for a comprehensive analysis, as industry standards can significantly influence the ratio’s acceptable values.
For instance, consider a company that has a combination of low-interest short-term debt and high-interest long-term debt.

Under this method, the Earnings Before Interest but After Taxes (EBIAT) is considered in the numerator. Since taxes are deducted from the earnings, the numerator is lower than both the EBIT and EBITDA methods. The denominator remains the same, yielding a lower ratio compared to EBIT and EBITDA methods. This method uses the Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) to calculate the ratio. Since depreciation and amortisation are included in the earnings, the numerator is higher compared to EBIT. As per a survey conducted on a sample size of about 1,900 companies, the Interest Coverage Ratio is said to have improved to 4.9% in Q2′ 21 from 1.8% in the previous year’s quarter.

A company’s ability to meet its interest obligations is an aspect of its solvency and is thus an important factor in the return for shareholders. This method gives a better picture of a company’s ability to pay the interest expenses because the taxes payable, which are a must, are deducted from the earnings. This method, thus, shows how affordably a company can pay the interest expense even after paying its tax liability. To analyse a firm’s financial statements, individuals should use the interest coverage ratio along with other metrics like – quick ratio, current ratio, cash ratio, debt to equity ratio, etc.

Fixed Charge Coverage Ratio (FCCR)

Generally, the interest coverage ratio is calculated using a company’s earnings before interest and taxes (EBIT) divided by its annual interest expense. Many metrics can help you determine the financial health and well-being of companies and, therefore, your investment portfolio. Knowing how to calculate it and using it with other valuable financial metrics can help you become a well-informed investor so you can make better decisions about your investments. The interest coverage ratio measures a company’s ability to handle its outstanding debt.

Interest Coverage Ratio: Formula & Examples

The interest coverage ratio is an accounting ratio that measures the ease of interest payment. Debt to equity ratio is used to know how much debt a company has for every rupee of equity it holds. Interest coverage ratio, however, tells us whether the company can pay interest on its borrowings. Several financial measures, including the interest coverage ratio, serve as a solvency check for an organisation. Using it, businesses, investors, and financial analysts can easily decipher the current ability of a firm to pay off its accumulated interest on a debt.

Ignoring the Cyclical Nature of Certain Businesses

Generally, a ratio below 1.5 indicates that a company may not have enough capital to pay interest on its debts. However, interest coverage ratios vary greatly across industries; therefore, it is best to compare ratios of companies within the same industry and with a similar business structure. The interest coverage ratio is a financial metric that measures a company’s ability to make interest payments on its debt. It’s calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expenses for the same period. Analyze the interest coverage ratio in conjunction with other financial ratios and debt ratios to gain a comprehensive understanding of a company’s financial health. Assessing this ratio over time can also help identify trends and evaluate a company’s ability to manage its debt over the long term.

On the other hand, an interest coverage ratio of more than 3.0 indicates that the company is able to pay its accumulated interest with its current operating income. Some lenders require that a company keep an interest coverage ratio of greater than 3.0. If that is the case, the requirement would typically be included as part of the debt covenant– a set of conditions and restrictions attached to the lending agreement. When looking at the accounts of any business, there should be a wide range of financial ratios and metrics used. No metric can be used in isolation to figure out the financial health of a company as they all have their pitfalls. However, it’s important to remember that the ICR is only one of many ratios and factors that credit rating agencies consider when determining a company’s credit rating.

While the standard ratio includes the earnings before interest, other ratios can modify the numerator to calculate the ratio. By analysing ICR, lenders can assess the borrowing company’s credibility and its capability to service the debt. Many banks accept payments online and lenders generally have ICR as part of their due diligence for loans. FCCR determines the company’s capacity to pay all of its short-term financial requisites. The EBITDA-to-interest coverage ratio is also known simply as as EBITDA coverage.