Pitfalls in Interest Coverage Analysis

Interest coverage is a financial model to indicate how easily a company can repay the interest on its debts in a given year. Nearly every company in America takes on loans in many forms, and the interest on these loans is a necessary part of operating a business. However, a company must maintain a profit high enough to easily cover this interest each year in order to protect against bankruptcy. Interest coverage is the metric used to determine how many times a company could pay its interest this year. Like all financial metrics, though, it has shortcomings.

Calculating Interest Coverage

Interest coverage is calculated by taking a company's earnings, including interest and taxes that will eventually be taken out of the profit, and dividing this sum by the total interest it owes. The numerator in the equation is often called Earnings Before Interest and Taxes (EBIT). Essentially, the metric uses the gross earnings of the company rather than net earnings to determine interest coverage.

Acceptable Interest Coverage

Acceptable interest coverage varies by industry. On the whole, it is necessary to have an interest coverage of at least 1/1 to indicate a company can pay its bills. Some industries, such as utilities, have a more stable profit margin than others. They can get by with a relatively low interest coverage close to 1. A company that has a more volatile earnings, like a retailer, will need a higher interest coverage, such as 3/1 or more. This will help the company get through slow business cycles.

Problems with the Metric

There is no "right" interest coverage for all companies across the board. An investor must be sophisticated enough to interpret this information and glean whether the company could survive a slow quarter. Some ways to do this include:

  • Comparing to other businesses in the same industry. Does the interest coverage for this company exceed or fall short of other highly rated stocks?
  • Comparing to other quarters and years. Even if a company maintains a low interest coverage ratio, if it maintains this quarter-by-quarter and year-by-year, this can point to financial stability. 

By interpreting the metric in these ways, you can overcome some of the issues involved with oversimplifying a complicated issue into a basic ratio. Be sure to consider the factors at play instead of just looking for a number.

Problems with the Calculation

A second problem that is harder to overcome involves the calculation itself. One potential issue is the deduction of taxes. To some people, it makes little sense to use the EBIT measure in the numerator of the formula. Since taxes are a sure thing, why not deduct them from the numerator up front? In this version of the formula, you would use earnings before interest (EBI), but deduct taxes from the start.

Another potential issue with the calculation is how to handle new interest taken on during the current year, particularly if it is assumed toward the end of the quarter or fiscal year. Ignoring this interest would not paint a comprehensive picture. Some financial minds like to prorate the interest to the current year in order to see a more accurate interest coverage ratio.

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