Interest Coverage Ratio is one of the Financial Ratio that use to assess the profitably and abilities that interest expenses could be paid by profit before interest and tax. It assess how profitable the entity could pay the interest liabilities or interest expenses.
Most of the investors and shareholders will look very strictly to see the interest expenses of the current period. These expenses are the result of short-term and long term debt that company borrow from banks. Sometime by others financial institution. However, some company borrow from its shareholders and parent company as well.
Interest Coverage Ratio measure how the profit, Earning Before Interest and Tax, could cover the interest expenses. This ratio is quite importance especially group of investors. The main reason is investors want the sharing of profit. It is called dividend. The dividend could only be share to them unless the company could earn the better profit after tax. If the interest expenses are too high, then what left to them will be small.
In this article, we will provide you the basis concept up to the critical analysis, formula and example. We hope it is the complete set of Interest Coverage Ratio.
Related article: Fixed Charge Coverage Ratio
Now, let move to the formula and example of it so that we could get better understanding.
Interest Coverage Ratio Formula
The formula is quite simple and straight forward,
It is calculate by Interest coverage ratio = Earning Before Interest and Tax (EBIT) / Interest expenses
So, as you could see the ratio here involve two main importance items. The first one is Earning Before Interest and Tax. And the second one is Interest Expenses.
Earning Before Interest and Tax is the profit that generate from operation. But these profit is before charging interest expenses and tax expenses for the period. The main reason that we take the EBIT is because of we want to analyst whether the profit before interest could pay interest or not.
Interest Expenses are the interest that entity need to pay to its bankers or creditors base on predetermine agreements for that period of time. It is different from interest payable. Sometime, it is less than or sometime it is higher than interest payable.
Related Article: Internal Rate of Return
ABC’s Profit and Lost Statement for the period end 31 December 2016 show Earning Before Interest and Tax amount $ 500,000 and Interest Expenses amount 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 complicate and difficult to interpret. And if you have problem in your calculation and interpretation, drop it here.