Interest coverage ratio
Interest Coverage Ratio
The interest coverage ratio is a measure of the number of times a company could make the interest payments on its debt with its earnings before interest and taxes, also known as EBIT (Total Income -total interest payment+tax)The lower the interest coverage ratio, the higher the company's debt burden and the greater the possibility of bankruptcy or default. This ratio used to determine how easily a company can pay interest on outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) of one period by the company's interest expenses of the same period:
To calculate the interest coverage ratio, divide EBIT (earnings before interest and taxes) by the total interest expense
Interest Coverage Ratio=EBIT/Interest income
EBIT (earnings before interest and taxes) ÷ Interest Expense = Interest Coverage Ratio
As per rule of thumb, investors should not own a stock that has an interest coverage ratio under 1.5. An interest coverage ratio below 1.0 indicates the business is having difficulties generating the cash necessary to pay its interest obligations. The history and consistency of earnings is tremendously important. The more consistent a company’s earnings, the lower the interest coverage ratio can be.