How to Calculate and Use the Interest Coverage Ratio
When it comes to risk management and reduction, the interest coverage ratio is one of the most important financial ratios you will learn. It does not matter whether you are a fixed income investor considering purchases of a company's bonds, an equity investor considering purchases of a company's stocks, a landlord contemplating property leases, a bank officer making recommendations on potential loans, or a vendor thinking about extending credit to new customers. The interest coverage ratio is a powerful tool in each of these circumstances.
For instance, for bondholders, the ratio is supposed to act as a safety gauge, as 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 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 understand the concept by applying it to yourself. Combine 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 and the higher the possibility of bankruptcy or default. Conversely, a higher interest coverage ratio signals a lower possibility of bankruptcy or default.
However, exceptions do exist. For example, a utility company with a single power generation facility in an area prone to natural disasters is probably a riskier business than a more geographically diversified company, even if the diversified company has a slightly lower interest coverage ratio. Also, unless a company with a low-interest coverage ratio possesses some sort of major offsetting advantage that makes it less risky, it will almost assuredly have bad bond ratings that increase the cost of capital.
General Guidelines for Investing
As a general rule of thumb, you should not own a stock or bond that has an interest coverage ratio below 1.5, and many analysts prefer to see a ratio of 3.0 or higher. A ratio below 1.0 indicates that the company has difficulties generating the cash necessary to pay its interest obligations.
The stability of profits is also tremendously important to consider. 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 due to what is known as a value trap.
The use of EBIT, however, also has its shortcomings because companies do pay taxes. It is, therefore, misleading to act as if they do not. To account for this shortcoming, 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 selecting 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 considered the interest coverage ratio to be a part of his "margin of safety." He borrowed the term from engineering and explained that, 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, and it's essentially a buffer to accommodate unexpected situations.
Deterioration of Interest Coverage Ratio
The interest coverage ratio can deteriorate in numerous situations, and you as an investor should be careful of these red flags. For instance, let's say that 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, so they will have to be rolled into more expensive liabilities this time around. That additional interest expense is going to affect the company's interest coverage ratio, even though nothing else about the business has changed.
Another, perhaps more common, situation 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 significant decline in the interest coverage ratio.