Interest Coverage Ratio
Interest coverage ratio shows company’s ability to pay interests for its financial debts. Interest coverage ratio is a ratio between operating profit (EBIT to be more exact) and expenses for interests. The lower this ratio is the worse situation company is facing. If the interest coverage ratio of the company is lower than 1 consistently for long term this may indicate that company is in a trouble and without additional funds one day may face solvency problems.
Interest coverage ratio is a good ratio for company’s financial stability measurement. However, this ratio should be used not more (at least together) than EBITDA coverage ratio which is very similar, only EBITDA is used instead of EBIT. The advantage is that EBITDA is higher by depreciation and amortization amount which is more reasonable in this case. Depreciation and amortization are theoretical expenses and management of company will suspend new investments if there will be any risk for solvency.
However both of these ratios cannot be measured out of the context. The results of companies’ do not stay the same and fluctuates all the time so interest coverage ratio also changes and should be interpreted in context of future prospects. The future of the company is more important than the past, and future depends mostly on macro economical conditions and sector environment including changes in competition.
Other nuances for interest coverage ratio are that this ratio may be wrong if company receives a lot of financial income. If company receives significant financial income it may have low EBIT and may have low interest coverage ratio (if somehow still pays interests) but the financial situation of such company might be very healthy. Naturally interest coverage ratio is not applicable for financial institutions as banks.
Other ratios to measure solvency risk of the company:
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