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Interest Coverage Ratio

Interest Coverage Ratio gives information about the company’s ability to pay interest on its long term loans as

per agreement.

FORMULA

Interest Coverage Ratio  =

Earnings Before Interest


Interest Charge

 

EXAMPLE

Interest Coverage ratio uses figures as presented in Statement of Comprehensive Income. Earnings before Interested can be extracted from face of Statement of Comprehensive Income however Interest Charge is a bit tricky. It might be presented in the Notes to the Financial Statements referred by Finance Cost figure presented on Statement of Comprehensive Income. I have assumed that Finance Cost presented on face is all interest charge.

 

Interest Coverage Ratio  =

900,350


3,485

Interest Coverage Ratio  =

258.35 times

Beware! If some interest is capitalized it will not appear in Statement of Comprehensive Income. You have to take that interest as well.
Data used in calculating ratio is extracted from Hypothetical Financial Statements. (See Hypothetical Financial Statements used in calculation).

MEASUREMENT UNIT

Interest Coverage ratio is measured in times per year.
Using the above example the company can pay the interest charge 258.35times in a year on borrowing / loans taken by the company.

INTERPRETATION

How to interpret the ratio

Interest Coverage Ratio gives us information about company’s ability to satisfy the interest obligation of the company in relation to the borrowing made by the company.

A ratio of 7 to 10 is acceptable. In other words company is in strong financial position to pay its interest on long term loans.

A ratio more than 10 shows that company is too conservative in using its strong financial position. The logic behind it is that capital invested in the company in the form of long term loans is cheap (company gets tax benefits) as compared to capital invested in the form of shares of the company. Therefore if company is not using its strong financial position to have capital in the form of long term loans then company is too conservative.

A ratio less than 7 indicates that company is not generating sufficient resources from its operating activities to pay interest charge on its long term debts. Generating profits is primary source of company to pay all its business expenses. Failure to do so will consequently result for company arranging other sources (selling long term and short term assets, more borrowings) for paying its business expenses (Interest charge is also a business expense). Furthermore low interest coverage might also create problems for company for further borrowings as lenders will be cautious to extend the loan facility.

Users’ needs addressed by the ratio


Lenders are most common users of long term solvency ratios as they have forwarded the long term loan to company and they want to ensure that company can yearly interest as well as principal back to lenders.

Management monitors the interest coverage ratio to avoid long term creditworthiness problems as well as litigations since nonpayment of interest may lead to litigation from lenders which can in worst scenario end in liquidation of the company.

(You must have an understanding of users’ needs of financial statements; please refer the topic 1- financial statement users for details).

 

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