Interest coverage ratio measures a company's financial leverage by calculating its ability to pay the interest on its loans. This ratio is calculated by dividing the company's earnings — prior to taking interest and taxes into account — by the amount of interest the company has to pay within a given time period. The higher the ratio, the better the company can withstand financial turmoil because of the capital it has in reserve. If the ratio falls below the base level of one, it means that the company's solvency is in jeopardy as it has lost the ability to cover its interest payments.
Borrowing money is a necessity for many businesses, as it allows them to grow in the developmental stages and make worthwhile investments to continue to expand. With loans come interest payments, and a financially stable company must generate enough income to not only make these payments but also have enough in reserve to withstand either a sudden downturn or a prolonged slump in revenue. Interest coverage ratio provides a good measuring stick for this type of financial stability, making it an important tool for those trying to decide about the viability of a potential investment.
To calculate the interest coverage ratio, the earnings before interest and taxes, or EBIT, must be calculated. That number is divided by the total interest charges levied on the company. Both the numerator and denominator in this equation must be taken from within the same time period to assure the ratio's reliability as an assessor of a company's financial strength.
When analyzing the interest coverage ratio, it's important to establish a benchmark level for what is considered an acceptable ratio. A ratio of 1.5 is often cited as the standard minimum level for a viable business. This level might have to be adjusted at times depending on the type of business being analyzed. For instance, if a business has a steady income flow, then the ratio doesn't need to be extremely high to sustain. A company in an industry that experiences high volatility would probably need a higher interest coverage ratio to withstand the fluctuations.
It's also important to realize that the interest coverage ratio is best utilized as an indicator of financial strength when studied over a long period of time, giving enough leeway for any short-term peaks and valleys to even out. Those wishing for an even stricter measuring stick can replace EBIT in the equation with earnings before interest, or EBI. That would reflect the taxes that a company has to pay, giving a truer account of how much financial leverage it has.
