Borrowing money is one of the most effective things a company can do to build its business. But, of course, borrowing comes with a cost: the interest that is payable month after month, year after year. These interest payments directly affect the company's profitability.
For this reason, a company's ability to meet its interest obligations, an aspect of its solvency, is arguably one of the most important factors in the return to shareholders.
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Interest coverage is a financial ratio that provides a quick picture of a company's ability to pay the interest charges on its debt.
The "coverage" aspect of the ratio indicates how many times the interest could be paid from available earnings, thereby providing a sense of the safety margin a company has for paying its interest for any period.
A company that sustains earnings well above its interest requirements is in an excellent position to weather possible financial storms. By contrast, a company that barely manages to cover its interest costs may easily fall into bankruptcy if its earnings suffer for even a single month.
The formula for calculating the interest-coverage ratio is as follows:
To simplify this (and express the formula in terms of a figure widely reported for most large companies), we can say that we are simply using earnings before interest and taxes (EBIT) as the numerator of the formula.
In other words, the interest-coverage ratio is calculated as follows:
Rules of Thumb for Analysis
Because interest coverage is a highly variable measure, not only between companies within an industry but between different industries, it is worthwhile to establish some guidelines for setting acceptable levels of interest coverage in particular industries.
Obviously, an interest-coverage ratio below 1 is an immediate indication that the company, regardless of its industry, is not generating sufficient cash to cover its interest payments. That said, an interest-coverage ratio of 1.5 is generally considered the bare minimum level of comfort for any company in any industry.
Beyond these absolute minimums, determining an acceptable interest coverage for an industry depends on its nature - or more specifically, the stability or consistency of its earnings.
For example, for an established utility company - a provider of power or water - an interest-coverage ratio of 2 is an acceptable standard. This fairly low minimum is justified by the consistent production and revenues that utilities tend to exhibit over the long term. Furthermore, rates for utilities may be set by governmental regulation, thereby projecting the future numerator of the interest-coverage calculation (earnings) with significant accuracy.
For more volatile industries, such as automobile manufacturing or steel production, an acceptable minimum for interest coverage is 3. Industrial companies such as these see more fluctuations in their production and consumption patterns from year to year. A greater margin of safety is therefore required to ensure the company can cover interest charges during periods when earnings are down.
An investor doing a thorough analysis of interest coverage determines how much total annual interest payments for each quarter of the past five fiscal years are covered by available earnings in each quarter. By analyzing five years of interest coverage for any company in any industry, we can gain a sense of the trend in the ratio.
At minimum, the ratio should be consistent quarter after quarter, year after year. Improving interest coverage is a positive signal of the company's overall health, and a declining pattern is a danger sign of a financial difficulty, which may be imminent or far off into the future. However, a declining ratio does not automatically mean death for the company, since a temporary change in operations can result in a blip in earnings.
For example, if a company's workers were to strike for a period of time, its interest-coverage ratio would suffer for that period. The analysis of an extended trend, over a period of at least several years, is always warranted.
Issues in Calculating Interest Coverage
Debt takes many forms from bonds, debentures, bank loans and notes payable, to other more complicated forms of debt units. It's logical to question whether the interest-coverage calculation should take all such forms of debt into account or instead weigh one kind of debt as more important than the others. The short answer is that all debt - whether short-term debt, senior debt or junior - should be considered equal in the calculation of the interest-coverage ratio. If a company should default on any one class, the default immediately affects the company's ability to meet the terms of the other debt, thereby precipitating a chain reaction of defaults.
Another question concerning the interest-coverage calculation is whether to include the full year's interest if new debt is issued later during the fiscal year. A conservative practice would be to prorate the interest charges for the entire year, as if the debt had existed for the entire year. This is a theoretical calculation that might give a better perspective of the effects of the debt in the next full fiscal year, and in years ahead.
However, such conservatism is not absolutely essential - it is acceptable to use the actual interest charges incurred during the year, even though this will result in a higher interest-coverage ratio. Because the funds generated from the debt issue have been at work for the company only for the same period as interest was charged, using only the charges for the year in the calculation does not likely skew the ratio drastically.
Because there are many factors at play in determining the value of both numerator and denominator in the interest-coverage calculation, it is important to recognize exactly what is causing any changes over time. Improving earnings are a good sign under any circumstances, but when accompanied by increasing interest expenses, their positive effect is tempered. Declining earnings combined with increasing interest charges are generally the worst-case scenario for the company, and the situation for which investors should be most alert.
Shortcomings of Interest Coverage
As we indicated above, the most widely used numerator in the interest-coverage calculation is earnings before interest and taxes (EBIT). Because it does not use earnings before interest (EBI), the calculation removes taxes from the calculation. Any time we remove such an important factor, we are inevitably diminishing the validity of our analysis by failing to take into account the broader picture of the company's operations. We could therefore argue for the inclusion of taxes in the calculation (use EBI instead of EBIT) in order to ensure that we account for any significant increases or decreases in a company's tax payments over time.
The Bottom Line
There are many other ratios available for analyzing a company's debt, including asset coverage, percentage of total capital ratios and debt/equity ratios, cash flow to total debt outstanding and preferred dividend coverage. The choice of ratio, or combination of ratios, to use when analyzing a company often comes down to the personal biases of the investor or analyst. Yet one would be hard-pressed to find reason to skip the interest-coverage ratio, which is arguably the "neatest" assessment of a company's short-term financial health. Any company that finds itself in jeopardy of defaulting on its interest payments is likely to encounter an escalating set of financial problems that are sure to affect the holdings of both shareholders and lenders.
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