What is Interest Coverage Ratio? (Definition, Using, Formula, Example, Explanation)

Definition:

The interest Coverage Ratio is one of the Financial Ratios used to assess the profitability and abilities that interest expenses could be paid by profit before interest and tax. It assesses how profitable the entity could pay the interest liabilities or expenses.

Most of the investors and shareholders will look very strictly to see the interest expenses of the current period. These expenses result from short-term and long-term debt that companies borrow from banks.

Sometimes by other financial institutions. However, some companies borrow from their shareholders and parent company as well.

Interest Coverage Ratio measures how the profit, Earning Before Interest and Tax, could cover the interest expenses. This ratio is quite important, especially group of investors.

The main reason is investors want the sharing of profit. It is called a dividend. The dividend could only be shared with them unless the company could earn a better profit after tax. If the interest expenses are too high, then what is left to them will be small.

This article will provide you with the basic concept, critical analysis, formula, and examples. We hope it is the complete set of Interest Coverage ratios.

Related article: Fixed Charge Coverage Ratio

Now, let’s move to the formula and example it to better understand it.

Interest Coverage Ratio Formula

The formula is relatively straightforward,

It is calculate by Interest coverage ratio = Earning Before Interest and Tax (EBIT) / Interest expenses

Or

interest-coverage-ratio

So, as you can see, the ratio here involves two main important items. The first one is Earning Before Interest and Tax. And the second one is Interest Expenses.

Related article  Liquidity Ratios (Definition, and List of Five Importance Ratios)

Earning Before Interest and Tax is the profit that generates from the operation. But this profit is before charging interest and tax expenses for the period.

The main reason we take the EBIT is that we want to analyze whether the profit before interest could pay interest or not.

Interest Expenses are the interest an entity needs to pay its bankers or creditors based on predetermined agreements for that period. It is different from interest payable. Sometimes, it is less than, or sometimes it is higher than the interest payable.

Related Article: Internal Rate of Return

Example:

ABC’s Profit and Loss Statement for the period ended 31 December 2016 shows Earning Before Interest, and Tax amount USD 500,000, and  Interest Expenses amount of USD 300,000.

Calculate the Interest Coverage Ratio of ABC.

Base on formula above, Interest Coverage Ratio is 500,000 / 300,000 = 1.66

In practice, the calculation might be more complicated to interpret. And if you have a problem with your calculation and interpretation, drop it here.