The interest coverage ratio is one of the most important financial ratios you can learn to reduce risk. It is a strong tool if you are a fixed income investor considering purchase of a company's bonds. It applies to an an equity investor who wants to buy a company's stocks. It also works for a landlord thinking about property leases, a bank officer making recommendations on potential loans, or a vendor thinking about extending credit to new customers.
Here's how it works. For bondholders. the ratio is supposed to act as a safety gauge. It sheds light on how far a company’s earnings can decline before the company begins defaulting on its bond payments. For stockholders, the ratio provides a clear picture of the short-term financial health of a business.
- The interest coverage ratio measures the number of times a company can make interest payments on its debt before interest and taxes (EBIT).
- In general, the lower the interest coverage ratio is, the higher the company’s debt burden, which increases the possibility of bankruptcy.
- A good rule of thumb is to not own a stock or bond with an interest coverage ratio below 1.5.
The Basics of Interest Coverage Ratio
The interest coverage ratio measures the number of times a company can make interest payments on its debt with its earnings before interest and taxes (EBIT). The formula is:
Interest Coverage Ratio = EBIT ÷ Interest Expense
While this metric is often used in the context of companies, you can better grasp the concept by applying it to yourself. Add up the interest expenses from your mortgage, credit card debt, car loans, student loans, and other obligations. Then calculate the number of times the expense can be paid with your annual pre-tax income.
Generally speaking, the lower the interest coverage ratio, the higher the company's debt burden is and the higher the chance of bankruptcy or default. On the flip side, a higher interest coverage ratio signals a lower risk of bankruptcy or default.
Still, exceptions do exist. A utility company with a single power generation facility in an area prone to natural disasters is probably a riskier business than a company with a more diverse geographic footprint. That's even if the latter company has a slightly lower interest coverage ratio. Also, a company with a low-interest coverage ratio will almost always have bad bond ratings that increase the cost of capital. That's even with some major offsetting advantage that makes it less risky,
General Guidelines for Investing
As a rule of thumb, you should not own a stock or bond with an interest coverage ratio below 1.5, Many analysts prefer to see a ratio of 3.0 or higher. A ratio below 1.0 indicates the company has trouble generating the cash needed to pay its interest obligations.
Profit stability is also quite important. The more consistent a company’s earnings, especially when adjusted for cyclicality, the lower the interest coverage ratio can get without concerning investors. Certain companies can appear to have a high-interest coverage ratio because of what's known as a value trap.
The use of earnings before interest and taxes (EBIT) also has its shortcomings because companies do pay taxes. It is misleading to act as if they do not. To account for this, you can take the company’s earnings before interest (but after taxes) and divide it by the interest expense. This figure should provide a safer metric to follow, even if it is more rigid than absolutely necessary.
If you are a bondholder, it may be helpful to take note of the guidance provided by value investor Benjamin Graham. Graham believed that picking fixed income securities was primarily about the safety of the interest stream that the bond owner needed to supply passive income. He asserted that an investor owning any type of fixed income asset should sit down at least once a year and re-run the interest coverage ratios for all of their holdings.
Graham believed the interest coverage ratio to be a part of his "margin of safety." He borrowed the term from engineering. For instance, when a 30,000-pound-capacity bridge is constructed, the developer may say that it is built for only 10,000 pounds. That difference of 20,000 pounds is the margin of safety. It serves as a buffer against surprises.
Deterioration of Interest Coverage Ratio
The interest coverage ratio can deteriorate in many situations. You, as an investor, should be careful of these red flags. For instance, let's say interest rates suddenly rise on the national level, just as a company is about to refinance its low-cost, fixed-rate debt. Those low-cost loans are no longer available. They will have to be rolled into more expensive liabilities. That extra interest expense affects the company's interest coverage ratio, even though nothing else about the business has changed.
Perhaps more common is when a company has a high degree of operating leverage. This does not refer to debt per se, but rather, the level of fixed expense relative to total sales. If a company has high operating leverage, and sales decline, it can have a shockingly disproportionate effect on the net income of the company. This would result in a sudden and steep decline in the interest coverage ratio.