MASTERCLASS Investment – Interest Coverage Ratio – How it helps to analyse a company for investing

MASTERCLASS Investment – Interest Coverage Ratio

Investment – Interest Coverage Ratio – How it helps to analyse a company for investing

The interest coverage ratio, (also known as interest cover or times interest earned) tells us how many times the profit/earnings  of a  company covers its total interest-payment expense bill.

The formula is calculated by dividing EBIT (earnings before interest and taxes) by the total Interest Expense. Note – some consider that using profit after tax is taken, instead of using BEFORE, is a better indication. See a detailed working calculation example.

Interest coverage is the equivalent of a person taking the total of their interest costs on mortgage, credit cards, car loans etc and dividing that into their annual after-tax salary/income.

Because the interest cover ratio uses current earnings and current expenses, it indicates a company’s short-term ability to meet interest obligations. Comparing the result between companies is ONE indication of management, the company’s short-term financial health/strength and another view on the company debt situation.

The lower the interest coverage result, the higher the company’s debt burden and the greater the possibility of bankruptcy or default especially if it not managed and remains low over time.

Generally, 1 or below is NOT desired, 1.5 is OK, but over 2 is seen as COMFORTABLE, and desired.

For legendary investor Benjamin Graham, the interest cover was an indication of the margin of safety available in the investment – he related it to investing in bonds. He borrowed the term from engineering, for example 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 allow for any unexpected situations.

Interest Cover is also important when interest rates are rising – especially if re-financing is required soon. A higher interest bill will reduce the interest ratio into warning values – and can be an important indicator if changing over time.

Some industries tend to have higher interest cover ratios than others, and cyclical companies in particular can experience significant swings in their interest cover ratios (especially during recessions).

Therefore, a comparison of interest cover ratios is generally most meaningful comparing companies within the same industry, and the definition of a “high” or “low” ratio should be made in this context.

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