The Interest Coverage Ratio

Interest coverage ratio is the number of times that the gross income covers the gross interest expense based on the annual income statement. This is an income statement ratio.

Components

The way to calculate interest coverage ratio is to find the gross interest and the gross income for the year. Then you will divide the gross income by the gross interest expense, this gives you interest coverage ratio. If the ratio is less than one then there is a major liquidity problem and eventually the balance sheet will have to decrease in order to pay off the interest in the coming years, all else being equal.

Why is it Used?

This ratio is commonly used by creditors to deem the credit quality or credit worthiness of a project or corporation. One of the major analysts' ratio, is in fact the interest coverage ratio. This is a broad estimate for ability to pay future debt expenses. If the ratio, for example, is high that means that the company will be able to bear greater debt at a cost that is considerably lower to a company that comparatively has a much lower ratio. This is key for companies that take on medium and long-term debt, because eventually those liabilities will become interest expenses on the annual income statement. Where as, short term credit lines are more revolving debt that is not supposed to end up on the annual income statement.

When it comes to investors and public relations as well as credit worthiness, a higher interest coverage ratio will lead to higher net income and better credit ratings for the firm. This creates a revolving cycle that is positive for the firm and allows the company to grow steadily.

Managing Debt

That is why it is important to manage the debt load carefully. Financial managers in the company will be wary in taking on new debt for new projects. Conversely, new companies that are not prudent will take on a large amount of debt because of their growth prospects, this heavy debt burden eventually leads them down a destructive financial path of bad revolving cycles that are influenced by an unhealthy balance sheet. These are issues that are kept within the confines of financial managers. That is why for new small companies that become bigger need to hire financial managers and reorganize themselves as a corporation. The company will not be able to compete otherwise.

Credit analysts like Moody's and Standard & Poor's look at ratios such as the interest coverage ratio to upgrade or downgrade a company based on its ability to meet its debt obligations. When the coverage ratio is low it runs a great risk of defaulting on its debt. This is an event that downgrades the credit rating, even being late on a payment can be deemed an event of default. This not only effects the credit rating, but its investment value in the stock and bond market as well. Therefore, as an individual investor you can use it as a benchmark.

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