What is the interest coverage ratio?
When it comes to risk management, the interest coverage ratio can be an essential tool for understanding whether your businesss revenues are high enough to pay the interest on your debt obligations. Find out everything you need to know, starting with our interest coverage ratio definition. Interest coverage ratio definition  The interest coverage ratio, sometimes referred to as the times interest earned ratio, is used to determine a companys ability to pay interest on its outstanding debt. Essentially, the ratio measures how many times a business can cover its current interest payments using its available earnings. This helps you understand your margin of safety for paying interest on debt over a given period. Most of the time, creditors, investors, and lenders use the interest coverage ratio formula to judge the risk of lending capital to a business. Businesses need to have a sufficient level of earnings to cover their interest payments. Otherwise, the business may not be able to survive any financial hardships that they encounter in the future. Put simply, your ability to pay the interest on your companys outstanding debt is a significant factor for solvency, which means that the interest coverage ratio formula plays a significant role in determining returns for shareholders. Also, the interest coverage ratio can give you crucial information about a companys short-term financial health. While its always difficult to make predictions about your businesss long-term outlook, the interest coverage ratio formula can help you understand whether the debt is becoming a burden for your company, rather than a liability that youre using to fund growth. A good interest coverage ratio is likely to vary from industry to industry. For example, the average debt obligations for businesses in the manufacturing and technology industries are dramatically different. Overall, an interest coverage ratio of at least two is the minimum acceptable amount. In most cases, investors and analysts will look for interest coverage ratios of at least three, which indicate that the businesss revenues are reliable and consistent. On the other hand, a bad interest coverage ratio is any number less than one, because this means that your businesss earnings arent sufficiently high enough to service your outstanding debt. Although it may be possible for companies that have difficulties servicing their debt to stay in business, a low or negative interest coverage ratio is usually a major red flag for investors. In many cases, it indicates that the firm is at risk of bankruptcy in the future. Understanding the interest coverage ratio formula  The interest coverage ratio formula is as follows:  Interest Coverage Ratio = EBIT / Interest Expense  In this calculation, EBIT (earnings before interest and taxes) represents the companys operating profit. Interest expense refers to the interest thats payable on your businesss borrowings, including lines of credit, loans, bonds, and so on. Lets look at an example. Imagine that Company A has an EBIT of $40,000 and total interest expenses of $5,000. In this scenario, the interest coverage ratio would work out to 2.66 ($40,000 / $15,000). In other words, Company A makes 2.66 more in earnings than their current interest payments, which means that it shouldnt have any trouble making payments, as operations are producing enough revenue to pay the bills. Interest coverage ratio variations  There are several different variations of the interest coverage ratio formula. One of the most prominent variations uses EBITDA (earnings before interest, taxes, depreciation, and amortisation) instead of EBIT. Using EBITDA in the interest coverage ratio will often give you a better result, as the calculation excludes depreciation and amortisation. As such, an EBITDA interest coverage ratio is a far more liberal take on the formula. We can help  GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.