How to Use Interest Coverage Analysis

Interest coverage is a mathematical expression of how easily a company could repay its debts if necessary. Essentially, the total cash reserves of a company are compared to the total interest it currently owes on debts. If the company could easily repay all of this debt with cash reserves, the company is in a strong financial position. A company that would struggle more with this process can present more risk to an investor. However, there is some interpretation with interest coverage that makes it more complicated than a simple ratio.

Low Interest Coverage Industries

There are some industries in which low interest coverage may be acceptable. For example, a utilities company sees very few swings in business. Even when the economy is up or down, a utilities company may post fairly consistent profit over the previous year. This type of company is known as "recession proof," and this reputation can extend into an interest coverage analysis. A company that is fairly resilient and has very predictable returns can afford to keep a little less cash on hand.

High Interest Coverage Industries

High interest coverage industries are much more vulnerable to market swings. These can include two primary areas: financial institutions and retail establishments. Financial institutions, including insurance companies, need large cash reserves in order to sustain large losses in a given year. A bank may suffer drastically if loans default; an insurance company will incur large losses in a year with high claims. Both of these companies should have enough reserves to pay down debts and cover the costs of these emergencies. Retail businesses also have inconsistent and unpredictable profits often tied to economic prosperity. These companies should carry high cash reserves to weather storms in the marketplace.

Variations in Interest Coverage Quarter-to-Quarter

One indicator of the strength of a company may be how consistent its interest coverage is over the course of the year. A company that continually relies on cash reserves, rather than profit, to pay for small emergencies will have a variable interest coverage. Again, an analysis of the industry may be useful. A bank should not have highly variable interest coverage during the course of a year. A clothing company, though, will build up reserves during the holiday and back-to-school seasons. The remainder of the year, the company may eat away at these reserves by operating at a loss. This company may be okay with variable interest coverage.

Variations in Interest Coverage Year-to-Year

Year-to-year, a company should post a consistent interest coverage. Even those retail establishments that may have varying rates during the course of the year should follow this general rule. A company with an increasing interest coverage over the years is posting large profits. The profits are substantial enough to repay debts, pay operating costs, invest and then save money in the cash reserve pot of the company. Companies that show a decreasing interest coverage are actually posting lower profits year-by-year, resulting in an inability to save money. This can expose the company to a high risk of bankruptcy in the immediate future.

blog comments powered by Disqus
Scottrade