MASTER CLASS – Interest Cover Pt 1 – Why it shows Strong Management

Many companies have debt to help them grow (unless debt gets too high)– buy assets such as equipment, take on staff and other costs that are expected to return an earning that will cover the cost (interest) for lending the money. If the interest payments are compared to the earnings (profit) we can get a feel for how much room to move is available should interest rates increase. Increased interest rates will mean less profit (earnings) and puts stress on the business.

Another way to look at it, is how easily a company can pay interest on outstanding debt. It is one measure of financial strength. http://www.accountingformanagement.com/interest_coverage_ratio.htm

The interest cover ratio is calculated as:

Earnings Before Interest and Taxes (EBIT) / Interest Expense

The lower the ratio, the more the company is burdened by debt expense. When a company’s interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable. An interest coverage ratio below 1 indicates the company is not generating sufficient revenues to satisfy interest expenses.

In general, a high coverage ratio may suggest a company is “too safe” and is neglecting opportunities to magnify earnings through leverage. An interest coverage ratio below 1.0 indicates that a company is not able to meet its interest obligations.
Because a company’s failure to meet interest payments usually results in default, the interest coverage ratio is of particular interest to lenders and bondholders and acts as a margin of safety. However, because the interest coverage ratio is based on current earnings and current expenses, it primarily focuses a company’s short-term ability to meet interest obligations.

 

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One Response to MASTER CLASS – Interest Cover Pt 1 – Why it shows Strong Management

  1. Thankyou for helping out, great info .

    Like

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