Important Features of Interest Coverage

Interest coverage is a calculation of how easily a company can pay off the interest on its debts given its current profits. This concept is relatively simple, and it is similar to an "income to debt" ratio in personal finance. Given your current income, how easily could you repay the interest on any debts you owe? If you could pay them off easily, you are making enough money for your current debt load. If it would be a struggle, your income may not be sufficient for the size of debt you carry. This is the basic structure of analyzing interest coverage for a company.

Earnings Before Income and Taxes

The first thing you need to know to evaluate a company's interest coverage is its income, or Earnings Before Income and Taxes (EBIT). This is generally accepted as the company's gross earnings. This is simply how much the company made from sales to customers or clients this year. The company has not yet factored out the expenses owed through taxes and debt payments; therefore, this is a completely unadjusted number. 

Interest

The second figure you need in order to evaluate a company's interest coverage is the total interest it owes on all current debts. This includes small business loans, credit card debts and debts to vendors. Once you know the interest owed, you simply use the formula:

EBIT / Interest = Interest Coverage

Obviously, the goal is for the earnings to be larger than the debt, so the answer should be 1 or larger. However, this is not always the case. This is where analysis comes into play.

Analyzing Interest Coverage

When a company is operating with an interest coverage between 1 and 1.5, its ability to repay debts would be considered questionable. For example, if you make $4,000 income each month and have a $3,000 mortgage payment, you are walking a fine line with being able to make that payment. On the other hand, if your mortgage were only $2,000, you would be operating at a coverage of 2, and you would be in much better position. The same is true for a company; the larger the coverage the better. If the coverage drops below one, then the company is in immediate risk of bankruptcy. Analysts can use interest coverage to show the relative strength of the company and determine how easily it can meet its financial obligations.

Flaws with Interest Coverage 

There are many criticisms of the interest coverage formula. First, some investors would like to use net profits instead of EBIT. This would be a greater indicator of a company's actual earnings, since the company must pay taxes and interest each year. Second, investors also criticize the fact that different industries will present different acceptable interest coverages. For example, a utilities company has a relatively stable business model poised to survive a recession. Operating at an interest coverage close to 1 may be acceptable. An auto manufacturer, however, is in a much more volatile business. It may need to keep an interest coverage of 3 just to be considered stable.

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