Interest Coverage Ratio

Interest coverage ratio is one of the most important ratios that need to be learned when assessing risk management and the possible reduction methods. Interest coverage ratio plays a very important role for stockholders and investors as it measures the ability of a business to pay interests on its outstanding debt.

It acts as a solvency check for the business organisation using which financial advisors, business analysts and investors can determine the ability of a business or a company to pay off the accumulated interest on the debt they are holding.

Interest coverage ratio is also known as debt service coverage ratio or debt service ratio. It is determined by dividing the earnings before interest and taxes (EBIT) with the interest expenses payable by the company during the same period.

In other words, the interest coverage ratio measures the number of times a company is able to make payments on its existing debt with the EBIT or earnings before interest and taxes. It is also known as the Times Interest Earned Ratio or TIE ratio.

Determining this ratio helps the lenders, investors, stockholders and debenture holders with the data on how efficiently the business or the company is able to make payment for interest due on the long term borrowings of the business.

An interest coverage ratio of 1.5 is considered as healthy for a business. In general, a higher interest coverage ratio means that a company is earning sufficient money in order to pay off the interests due on long term loans, which indicates that there is a very less chance of a financial default.

Similarly, a low interest coverage ratio indicates a higher debt burden on the company which increases the chances of bankruptcy. In such cases banks would hesitate to provide credit to the business.

Calculating Interest Coverage Ratio

The interest coverage ratio can be represented by the following formula

Interest Coverage Ratio = EBIT / Interest Expenses

Where EBIT = Earnings before interest and taxes

Interest Expenses = Interest payable on long term borrowings

Let us understand the concept of interest coverage ratio with a solved example.

Solved Example

Unreal Inc. has the following details from their accounting records

Sales Revenue = 500,000

COGS = 120,000

Operating expenses in the form of

Salary – 50,000

Rent – 40,000

Utilities – 20,000

Interest Expense – 30,000

Find the interest coverage ratio from the above provided information.

Answer:

We know that,

EBIT = Total Revenue – COGS – Operating Expenses

Therefore,

Operating expense = 50,000 + 40,000 +20,000

= 1,10,000

Now,

EBIT = 500,000 – 120,000 – 110,000

= 2,70,000

Therefore,

Interest Coverage Ratio = EBIT / Interest Expenses

= 2,70,000 / 30,000

= 9

This indicates that Unreal Inc. has the ability to pay the interest on the debt 9 times in an accounting year.

This concludes our article on the topic of Interest Coverage Ratio, which is an important topic in Class 12 Accountancy for Commerce students. For more such interesting articles, stay tuned to BYJU’S.

Leave a Comment

Your Mobile number and Email id will not be published. Required fields are marked *

*

*