Interest coverage, also known as interest coverage ratio or times interest earned (TIE), is a financial ratio that measures a company’s ability to pay off its interest expenses on outstanding debt. It’s calculated by dividing a company’s earnings before interest and taxes (EBIT) by the interest expense during the same period. This ratio shows investors and creditors the proportion of earnings available to cover interest payments. The higher the ratio, the better the company’s financial health.
1. What is a good interest coverage ratio?
A good interest coverage ratio is typically 1.5 or higher. This value implies that the company can cover its current interest payment obligations with its available earnings. However, a healthy ratio may vary by industry.
2. Why is the interest coverage ratio important?
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The interest coverage ratio is important because it shows a company’s ability to handle its debt. It helps investors gauge the risk involved in investing in the company, and it helps creditors decide whether to lend money to the company.
3. Can a company have a negative interest coverage ratio?
Yes, if a company’s earnings are less than its interest obligations, it can result in a negative interest coverage ratio. This is a strong indicator that the firm is in financial distress.
4. What is the difference between the interest coverage ratio and the debt service coverage ratio?
The interest coverage ratio only considers the interest expense, while the debt service coverage ratio takes into account the company’s principal repayments on its debts along with the interest.
5. How is the EBIT calculated for the interest coverage ratio?
Earnings before Interest and Taxes (EBIT) is calculated by subtracting the cost of goods sold and operating expenses from the revenue. This figure represents the profit a company generates from its operations.