How to Calculate the Interest Coverage Ratio
When it comes to risk management and risk reduction, the interest coverage ratio is one of the most important financial ratios you, as an investor and business owner, will ever learn. It doesn't matter if you are a fixed income investor considering purchasing bonds issued by a company, an equity investor considering buying stock in a firm, a landlord contemplating leasing a property to an enterprise, a bank officer making a recommendation on a potential loan, or a vendor thinking about extending credit to a new customer, knowing how to calculate it in a few seconds can give you a powerful insight into the health of company.
What Is the 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.
Interest coverage is the equivalent of a person taking the combined interest expense from his or her mortgage, credit card debt, automobile loans, student loans, and other obligations, then calculating the number of times it can be paid with their annual pre-tax income. For bondholders, the interest coverage ratio is supposed to act as a safety gauge. It gives you a sense of how far a company’s earnings can decline before it will begin defaulting on its bond payments. For stockholders, the interest coverage ratio is important because it gives a clear picture of the short-term financial health of a business.
Generally speaking, the lower the interest coverage ratio, the higher the company's debt burden and the greater the possibility of bankruptcy or default. The converse is also true. That is, the higher the interest coverage ratio, the less the chance of default.
Exceptions do exist. For example, a utility company with a single power generation facility in an area prone to natural disasters is probably far riskier despite having a higher interest coverage ratio than a more geographically diversified firm with a slightly lower metric. All else equal, unless it possesses some sort of major offsetting advantage that makes the risk of non-payment low, a company with a low-interest coverage ratio will almost assuredly have bad bond ratings, increasing the cost of capital; e.g., its bonds will be classified as junk bonds rather than investment grade bonds.
To calculate the interest coverage ratio using the figures found on the income statement, divide EBIT (earnings before interest and taxes) by the total interest expense.
EBIT (earnings before interest and taxes) ÷ Interest Expense = Interest Coverage Ratio
As a general rule of thumb, investors should not own a stock or bond 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 stability of profits are tremendously important. The more consistent a company’s earnings, especially adjusted for cyclicality, the lower the interest coverage ratio can be. Certain businesses can appear to have a high-interest coverage ratio due to something known as a value trap.
EBIT has its shortcomings, though, because companies do pay taxes. Therefore, it is misleading to act as if they didn’t. A wise and conservative investor would simply take the company’s earnings before interest and divide it by the interest expense. This would provide a more accurate picture of safety, even if it is more rigid than absolutely necessary.
The father of value investing and the entire securities analysis industry, legendary investor Benjamin Graham, wrote a considerable amount during his career about the importance of the interest coverage ratio, especially as it pertained to bond investors making bond selections. 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 his or her holdings.
If the situation deteriorates for a given issue, history has shown there is often a window of time when it is not particularly painful to switch out to a practically identical bond, with much better interest coverage, for nominal costs. This isn't always the case, and it may not continue to be in the future, but it arises because many investors simply do not pay attention to their holdings.
In fact, we are seeing this situation play out at the moment. J.C. Penney is in considerable financial trouble. It has 100-year maturity bonds that it issued back in 1997, leaving another 84 years before maturity. The retailer has a very decent probability of going into bankruptcy or experiencing further declines, yet the bonds are still yielding 11.4% when they should be yielding much more given the inherent risk in the position. Why aren't J.C. Penney bond owners switching to more secure holdings?
That is a good question. It happens again and again, company after company. It's the nature of the debt markets. A shrewd, disciplined investor can avoid this kind of folly by paying attention from time to time.
Graham called this interest coverage ratio part of his "margin of safety"; a term he borrowed from engineering, explaining that when a bridge was constructed, it may say it is built for 10,000 pounds, while the actual maximum weight limit might be 30,000 pounds, representing a 20,000 pound margin of safety to accommodate unexpected situations.
One situation in which the interest coverage ratio might suddenly deteriorate is when interest rates are rising quickly, and a company has a lot of very low-cost fixed-rate debt coming up for refinancing that it is going to need to roll over into more expensive liabilities. That additional interest expense is going to hit the coverage ratio even though nothing else about the business has changed.
Another, perhaps more common, situation is when a business 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 firm. This would result in a sudden, and equally excessive, decline in the interest coverage ratio, which should send up red flags for any conservative investor. (On the flip side, this situation leads to a special type of investment operation that actually causes people to seek out ownership of bad businesses when they think the economy is likely to recover given that they experience bigger upswings as the operating leverage effect happens in reverse.)