Interest Coverage Ratio
Definition of 'Interest Coverage Ratio'
The interest coverage ratio is the determination of how easily/timely a company can pay the interest on debt or loans. A healthy company can meet not only interest payments but principal as well. A low interest coverage ratio, also known as times interest earned, may deter lenders from providing additional funding to companies.
TheStreet Explains ‘Interest Coverage Ratio’
Unfortunately, when a business can only meet the interest payments on debt, the company is more vulnerable to failure. To determine the debt health of a company and calculate the interest coverage ratio, divide the earnings before interest and taxes (EBIT) by the interest expense occurring simultaneously.
An interest coverage ratio under 1.5 is a red flag to lenders, which may mean the company can only meet interest payments and cannot touch the loan principal. The extreme danger zone for a company is an interest coverage ratio under 1--this signals imminent collapse unless the company can spend its cash reserves to adequately meet debt requirements. While an interest coverage ratio under 1.5 signals trouble, businesses should aim to be over 2.5, which still means the company is treading water but is not free from danger.
Although loans are a vital component to growth, companies should be prudent and perform due diligence before closing on an interest-bearing loan. Businesses should forecast how interest payments will impact the cost of doing business, the ease of how well the company can handle not only the interest but also loan principal, while at the same time using the borrowed money for efficient growth.
Because the interest coverage ratio is a good measurement of short-term financial status, business managers use the ratio to measure overall stability and trends (future and past). Although the ratio is an important corporate measurement, the interest coverage ratio is not without its drawbacks. One limitation is not taking into account the level of establishment the company has in the market as well as taking into consideration the type of business and productivity levels. Two companies could have the same interest coverage ratio but a well-established manufacturer with a product that is high in demand would be in a better position and not considered a risk.
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The interest coverage ratio is the determination of how easily/time...
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