Interest Coverage Ratio: Assessing a Company’s Debt Servicing Ability

Ravi understood that while debt could fuel growth, it could also become burdensome if not well managed. Realising that debt levels alone don’t paint the full picture, he delved into the Interest Coverage Ratio, a metric that shows how comfortably a company can pay its interest obligations with its earnings.

What is the Interest Coverage Ratio?

The Interest Coverage Ratio measures how easily a company can meet its interest payments on outstanding debt. It’s calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expenses: Interest Coverage Ratio = EBIT / Interest Expense

• Example: A company with an EBIT of ₹10 lakh and interest expenses of ₹2 lakh has:
  Interest Coverage Ratio = 10,00,000 / 2,00,000 = 5

This means the company can cover its interest payments five times over, indicating a comfortable financial position.

Understanding the Interest Coverage Ratio

This ratio, also called "times interest earned (TIE)," helps investors assess a company’s ability to handle interest payments, indicating its financial stability.

• High Ratio: A high value means the company has a significant buffer, suggesting stability and less risk.
• Low Ratio: A low value, especially below 1.5, suggests financial strain, increasing the risk of default if earnings decline.

For instance, a ratio of 1.5 means the company can only cover its interest payments 1.5 times, which could be insufficient if its revenue dips.

Variations in Earnings Measurements

Different earnings metrics can alter the ratio’s interpretation:

• EBITDA: Excluding non-cash expenses like depreciation provides a higher, potentially optimistic ratio—useful for asset-heavy firms.
• EBIAT: Subtracting taxes from EBIT offers a conservative view by considering tax impacts on debt servicing.

What the Ratio means for Investors

The Interest Coverage Ratio indicates a company’s solvency. Analysing it over time shows trends in financial health:

• Improving Ratio: Suggests growing profitability and better debt management.
• Declining Ratio: Can signal trouble, especially if it falls below critical levels, potentially making the company riskier for investors and lenders.

When a Low-Interest Coverage Ratio becomes concerning

A ratio below 1.5 often raises red flags. It indicates a limited buffer, making the company vulnerable to unexpected financial stress:

• Example: A manufacturing firm with a ratio of 1.3 can currently meet interest obligations, but even a slight dip in sales could make debt servicing difficult.

Limitations of the Interest Coverage Ratio

While insightful, the ratio has its limitations:

• Industry Differences: Different industries have varying standards, affecting what qualifies as an acceptable ratio.
• Principal Repayments: The ratio covers only interest, not the principal debt, so a high ratio doesn’t always mean financial health.
• Inconsistent Definitions: Companies may define debt differently, affecting comparisons.

Using the Interest Coverage Ratio to assess Risk

Ravi learned that while valuable, this ratio should be assessed alongside revenue stability, growth, and overall debt levels. A steadily declining ratio may indicate a growing dependence on debt and reduced ability to meet obligations.

Conclusion

The Interest Coverage Ratio enabled Ravi to gauge a company’s comfort in meeting debt obligations, helping him understand if it had a sufficient cushion for unforeseen challenges.

In the next chapter, we’ll explore the Cash Ratio—a metric for assessing a company's ability to cover short-term obligations with its most liquid asset: cash, further deepening insights into financial stability and liquidity.