Financial Statement Analysis
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- Financial Leverage Ratio
- Financial Leverage Formula
- Net Debt Formula
- Leverage Ratios
- Operating Leverage vs Financial Leverage
- Current Yield
- Debt Yield Ratio
Interest Coverage Ratio – Most of the companies have borrowings (long term as well as short term) and they have to pay interest on the same. The investors need to keep a check on the fact whether the company will be able to pay the interest on a timely basis. For this, a financial ratio named as “Interest Coverage Ratio” is very helpful. As we can see from above chart, Nissan has an extremely healthy interest coverage ratio as compared to its peers – Ford and Daimler.
Interest coverage ratio helps to determine how easily a company can pay interest on its outstanding debt / borrowings. Interest coverage ratio is classified as a Debt Ratio – which gives a general idea about the financial structure and the overall financial risk faced by a company. Interest coverage ratio can also be classified as a Solvency Ratio – which helps to understand if the organization is solvent and whether there are any near threats pertaining to bankruptcy.
In this article, we look at Interest Coverage Ratio in Detail –
- What is Interest Coverage Ratio?
- Interest Coverage Ratio Formula
- Interest Coverage Ratio of Colgate
- Interpretation of the Interest Coverage Ratio
- Usefulness of the Interest Coverage Ratio
- Limitations of Interest Coverage Ratio
- Best way of using Interest Coverage Ratio
- Industry Example of Interest Coverage Ratio
What is Interest Coverage Ratio?
Interest Coverage Ratio is a ratio which helps to decode whether the company will be able to pay interest on a timely manner.
Mr. Benjamin Graham (author of the famous book named The Intelligent Investor) called the interest coverage ratio as a part of “margin of safety”. He explained this term by comparing it to the engineering of a bridge. On the construction of a bridge, the weight it can carry is declared as say 10,000 pounds, while the actual maximum weight limit which it is built for is 30,000 pounds. This extra 20,000 pound represents the margin of safety to accommodate unexpected situations. In the same way, interest coverage ratio represents the margin of safety with regards to an organization’s interest payments.
To a certain extent, this ratio also helps to measure financial stability of the company or the hardships it can face on account of its borrowings.
Equity and debt are the two sources of funds for any company. Interest is the cost of debt for the organization. Analyzing whether a company is in a position to pay this cost is very important. Therefore, this is a very critical ratio for the shareholders and the lenders of the company.
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Interest Coverage Ratio Formula
Interest coverage ratio is calculated with a simple formula as follows:
#1 – Interest Coverage Formula using EBIT
Interest Coverage Ratio = EBIT for the period ÷ Total Interest Payable in the given period
Here, EBIT stands for Earnings before Interest & Tax
Let us understand this formula better with the help of the following example.
M/s High Earners Limited | ||
Abstract of the Revenue Statement for the period 01-Jan-2015 to 31-Dec-2015 along with the
Comparative Revenue Statement for the period 01-Jan-2014 to 31-Dec-2014 |
||
Particulars | Year | |
2015 | 2014 | |
Revenue: | ||
Project Advisory Fees | $ 1,30,000 | $ 1,50,000 |
Consultancy Fees | $ 70,000 | $ 36,000 |
Total Revenue (A) | $ 2,00,000 | $ 1,86,000 |
Expenses: | ||
Direct Expenses | $ 1,00,000 | $ 95,000 |
Advertisement Expenses | $ 2,000 | $ 1,800 |
Commission Paid | $ 1,140 | $ 600 |
Miscellaneous Expenses | $ 360 | $ 300 |
Depreciation | $ 8,300 | $ 8,600 |
Total Operating Expenses (B) | $ 1,11,800 | $ 1,06,300 |
Operating Income (A minus B) | $ 88,200 | $ 79,700 |
Add: Other Income | $ 2,000 | $ 2,100 |
Less: Other Expenses (if any) | $ 100 | $ 76 |
Earnings before Interest & Tax | $ 90,100 | $ 81,724 |
Less: Interest | $ 9,200 | $ 8,000 |
Profit before Tax | $ 80,900 | $ 73,724 |
Less: Taxes (assumed @ 10%) | $ 8,090 | $ 7,372 |
Profit After Tax | $ 72,810 | $ 66,352 |
Interest Coverage Ratio for the year 2015 = $ 90,100 ÷ $ 9,200 = 9.99
Interest Coverage Ratio for the year 2014 = $ 81,724 ÷ $ 8,000 = 10.07
#2 – Interest Coverage Formula using EBITDA
A slight variation of the above formula is to add any non-cash expenses to EBIT (EBITDA) and then calculate the Interest Coverage Ratio.
Formula for the same is as follows:
Interest Coverage Ratio Formula = (EBIT for the period + Non-cash expenses) ÷ Total Interest Payable in the given period
Non cash expense is Depreciation and Amortization for most companies.
To understand this formula, first, let us understand what do we mean by Non-cash expenses. As the name itself suggests, these are expenses incurred in the Books of Account but there is no actual cash outflow on account of these expenses. A very good example of this is depreciation. Depreciation measures the wear and tear of the fixed assets on a yearly basis but does not lead to any cash outflow.
The logic behind adding these Non-cash expenses is to arrive at a figure which will be available for payment of interest in the true sense and not just as per book profit. If we add these expenses, the interest coverage ratio will definitely increase.
Taking the above example,
Interest Coverage Ratio for the year 2015 = ($ 90,100 + $ 8,300) ÷ $ 9,200 = 10.58
Interest Coverage Ratio for the year 2014 = ($ 81,724 + $ 8,600) ÷ $ 8,000 = 12.04
Financial Analysts use either the first formula or the second formula depending on what they feel is more appropriate.
Interest Coverage Ratio of Colgate (using EBITDA Method)
Let us not calculate Interest coverage ratio of Colgate. In this example, we will use the EBITDA formula. Colgate’s Interest Coverage Ratio = EBITDA / Interest Expense (using the 2nd formula)
- Colgate’s Interest Coverage Ratio = EBITDA / Interest Expense
- In Colgate, Dep & Amortization expense were not provided in the Income Statement. You can easily find those in the Cash flow from operations section.
- Also, please note that the Interest expense is the net amount in the Income Statement (Interest Expense – Interest Income)
- As we can note, Interest coverage of Colgate is very healthy. It has maintained interest coverage ratio in excess of 100x for the past two years or so.
- Also in 2013, the Net Interest Expense was negative (Interest expense – Interest Income). Hence the ratio was not calculated.
Interpretation of the Interest Coverage Ratio
Interest coverage ratio is a solvency check for the organization. In simple words, the ratio measures the number of times interest can be paid with the given earnings of the company. Therefore, higher the ratio, better it is. A higher ratio means that the organization has sufficient buffer even after paying interest. In the above example, M/s High Earners Limited has an interest coverage ratio of approximately 10 for 2014. This means it had enough buffer to pay the interest for 9 times over and above the actual interest payable.
Putting it in other words, one can say that lower the ratio, more the burden on the organization to bear the cost of debt. When the ratio dips below 1.5, it means a red alert for the company. It indicates that it may barely be able to cover its interest expenses. Anything below 1.5 means the organization might not be able to pay interest on its borrowings. There are high chances of default in this case. It may also create a very negative impact on the goodwill of the company as all the lenders will be very cautious about their invested capital and any prospective lenders will shy away from the opportunity.
Also, in case the company is unable to pay interest, it may end up borrowing more. This generally worsens the situation and leads to a loop where the company keeps on borrowing more to cover its interest expense.
Now, what happens if the interest coverage ratio actually falls below 1? In this case, it means that the company is not generating enough revenue which is why the Total Interest Payable is more than the Earnings Before Interest & Tax. This is a strong indicator of default. This often leads to the risk of falling into bankruptcy.
Have a look at the below graph. Canadian Natural Interest Coverage ratio is now at -0.91x (less than 0). Such a position is not good for the company as they do not have sufficient earnings to pay down its interest expense.
source: ycharts
In most cases, a minimum interest coverage ratio should be around 2.5 to 3. This much is enough to not trigger a red flag. However, there can be many instances where a company has to maintain a higher ratio, such as:
- A strong internal policy where the management has mandated to maintain a higher ratio.
- There may also be a contractual requirement of various borrowers of the company to maintain a higher ratio.
Also, different industries may have a different level of acceptability of interest coverage ratios. Generally, industries where the sales are stable such as basic utilities can do with a lower interest coverage ratio. This is because they have a comparatively steady EBIT and their interest can easily be covered even in case of difficult times.
Whereas, industries which tend to have fluctuating sales such as technology should have a comparatively higher interest coverage ratio. Here, the EBIT will fluctuate in accordance with sales and the best way to manage cash flow is by keeping buffer cash by maintaining a higher ratio.
Another interesting point to note about this ratio is that a higher EBIT is not a proof of a higher interest coverage ratio. From the above comparative analysis of two years of revenue of M/s High Earners Limited, we can conclude the same. Year 2014 has a lower profit but still it is in a slightly better position to pay off its interest expense as compared to year 2015. Even though the profit is lower in 2014, the interest is also lower in the year and hence a higher Interest Coverage Ratio.
Usefulness of the Interest Coverage Ratio
Some of the very important uses of the interest coverage ratio are:
- Trend analysis of the interest coverage ratio will give a clear picture of the stability of the organization with regards to its interest payments and defaults if any. For example, a company having a consistent interest coverage ratio over a period of 5 years is comparatively simple as compared to a company which has an interest coverage ratio fluctuating on a yearly basis
Company A | 2015 | 2014 | 2013 | 2012 | 2011 |
Earnings before Interest & Tax | $ 12,000 | $ 10,000 | $ 8,000 | $ 6,000 | $ 4,000 |
Interest | $ 1,150 | $ 950 | $ 800 | $ 660 | $ 450 |
Interest Coverage Ratio | 10.43 | 10.53 | 10.00 | 9.09 | 8.89 |
Company B | 2015 | 2014 | 2013 | 2012 | 2011 |
Earnings before Interest & Tax | $ 12,000 | $ 10,000 | $ 8,000 | $ 6,000 | $ 4,000 |
Interest | $ 8,000 | $ 5,500 | $ 4,000 | $ 4,100 | $ 3,500 |
Interest Coverage Ratio | 1.50 | 1.82 | 2.00 | 1.46 | 1.14 |
From the above interest coverage ratio, we can see that Company A has steadily increased its interest coverage ratio and appears to be stable in terms of solvency and growth. At the same time, Company B has a very low ratio and also there are ups and downs in the ratio. This indicates that Company B is not stable and can face liquidity issues in the foreseeable future.
- Before lending money through short term / long term instruments, lenders can evaluate the interest coverage ratio on Budgeted data and evaluate the credit worthiness of the company. A higher ratio is what lenders will look at.
- Interest coverage ratio is also a good indicator for other stakeholders such as investors, creditors, employees, etc. to take timely decisions.
Taking a reference to the above examples of Company A and Company B, an employee would definitely want to work for Company A rather than Company B to ensure his or her job security. On the same lines, if an investor has invested money in Company B, he may want to withdraw his investments referring to the above trend analysis.
Limitations of Interest Coverage Ratio
Like every other financial ratio, interest coverage ratio has its own set of limitations as well. Some of the limitations are as follows:
- Looking at the ratio for a given period may not give you the true picture of the company’s position as there can be seasonal factors which can hide / distort the ratio.
For example, in a given period the company has exception revenue on account of a new product launch which is already banned by the government going forward. Looking at the interest coverage ratio only in this period may give the impression that the company is doing well. However, if the ratio is compared to the next period, it might show a totally different picture.
- An important shortcoming of the ratio is that the ratio does not consider the effect of Tax Expense to the organization. Tax expense is deducted after Earnings Before Interest & Tax. Tax affects the cash flow of the organization and it can be deducted from the Numerator of the ratio to arrive at better results.
- Consistency in accounting policies and principles followed while preparing Financial Statements can also be a critical factor in analyzing past trends and comparing industry peers while calculating the interest coverage ratio.
Best way of using Interest Coverage Ratio
The best way to use financial ratios is to use an umbrella of ratios at a given point of time. Many other financial ratios such as cash ratio, quick ratio, current ratio, debt equity ratio, price earnings ratio, etc. should be used along with the interest coverage ratio for effective analysis of the Financial Statements. This helps to maximize the advantages of these ratios and at the same time minimize their limitations.
Industry Example of Interest Coverage Ratio
Following is the extract of Profit & Loss Accounting of a few prominent Telecomm industry players for the Financial Year 2015-16
Particulars | Idea Cellular | Bharti Airtel | Tata Comm |
(All Amounts in Rupees Crores) | |||
Income | |||
Sales Turnover | 35816.55 | 60300.2 | 4790.32 |
Other Income | 183.44 | 805.7 | -89.6 |
Total Income (A) | 35999.99 | 61105.9 | 4700.72 |
Expenditure | |||
Raw Materials | 0 | 51.6 | 20.77 |
Power & Fuel Cost | 2460.36 | 4038.7 | 83.56 |
Employee Cost | 1464.44 | 1869.3 | 789.65 |
Other Manufacturing Expenses | 18708.9 | 15074.7 | 1828.73 |
Miscellaneous Expenses | 1358.59 | 16929.7 | 896.76 |
Total Expenses (B) | 23992.29 | 37964 | 3619.47 |
Profit Before Depreciation, Interest & Tax
(A – B) |
12007.7 | 23141.9 | 1081.25 |
Less: Depreciation | 6199.5 | 9543.1 | 745.56 |
Earnings Before Interest & Tax | 5808.2 | 13598.8 | 335.69 |
Interest | 1797.96 | 3559 | 20.45 |
Interest Coverage Ratio | 3.23 | 3.82 | 16.42 |
If we compare the interest coverage ratio of the above three companies, we can easily see that Tata Communication has enough buffer cash to pay off all its interest commitments but at the same time it has profit which has considerably lesser than the other two companies.
On the other hand, Idea and Bharti Airtel both have interest coverage ratios on a lower side but not low enough to raise a red flag. A prudent investor who looks at more stability and security might opt for Tata Communications whereas investors who are willing to take a bit more risk will go with higher profit companies but lower interest coverage ratio like Bharti Airtel.
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