A major concern of all business managers and lenders is the ratio of interest and principal payments a company has to make in proportion to its income. Just like homeowners, payments should not exceed one's ability to make the mortgage payments. The interest cover ratio is one way to gauge the ability of a company to meet its debt payment obligations.
TL;DR (Too Long; Didn't Read)
The interest cover ratio, also known as times interest earned ratio, is a measure of the ability of a company to meet its interest obligations. It is the number of times a company's earnings exceeds its interest payments.
What Is the Coverage Ratio Formula?
The coverage ratio formula is the annual amount of a company's earnings before interest and taxes divided by the interest expenses for the same period.
Interest Cover Ratio = Earnings before interest and taxes/interest expense
What Does the Interest Cover Ratio Mean?
The interest cover ratio is a measure of the solvency and long-term financial health of the business. In general, a higher interest coverage ratio shows that the company has a lower amount of debt and is less likely to default. Investors and lenders consider a coverage ratio of two as the minimum acceptable amount. A ratio below one means that the company does not have enough income to meet its current interest payments and is in poor financial health.
Companies with low-interest coverage ratios will receive lower bond ratings. Poor bond ratings, maybe even a junk bond classification, means that companies have to pay higher interest rates, which makes their coverage ratios even worse.
While it would seem that higher interest coverage ratios are better than lower ones, that is only true up to a point. A high ratio means that the company has a low amount of debt and may be missing investment opportunities by not taking advantage of its available financial debt capacity.
What About Lease Payments?
Some businesses lease equipment and facilities instead of borrowing money to buy the assets. These lease payments are a substitute for interest payments. In this case, the interest cover ratio may look attractive because it lowers the company debt. However, this could be a misleading indicator since the company must allocate a portion of its earnings to make the lease payments.
Consequently, it is more realistic to include a company's lease payments along with its interest obligations when calculating the times interest earned ratio.
While the debt ratio is a gauge of a company's total debt relative to its total assets, the interest cover ratio shows whether the company has sufficient earnings to pay the interest expense. If a company has a history of volatile earnings, its times interest earned ratio should be revisited each year to get a current feeling for the financial strength of the business.