Understanding interest coverage ratio

INTEREST COVERAGE RATIO

This ratio relates the fixed interest charges to the income earned by the business. It indicates whether the business has earned sufficient profits to pay periodically the interest charges. It is calculated by using the following formula.

  • Interest Coverage Ratio = Net Profit before Interest and Tax /Fixed Interest Charges

What it shows is:

1. The amount of interest expense the company bears in a current year due to loan funds and its impact on profitability.

2. The profit of the company in terms of ‘number of times’ the interest obligation. This information would show the financial strength of the company. A company which merely manages to generate the required income to pay interest obligations is prone to severe liquidity crisis.

3. An interest coverage ratio of less than 1 is an indication that the company is not generating enough cash to pay its interest obligations.

4 . Any improvement in interest coverage ratio is a good sign. On the same lines, any decrease in the interest coverage ratio of the company is a red flag.

WHAT KNID OF DEBTS ARE TO BE INCULDED?

All kind of Debts of a company- long term, short term, bank loans, bonds, debentures, notes payable.. In fact, any form of debt for which there is an obligation on the part of the company to pay interest should form part of this calculation.

ICR- A part of debt ratios.

The ICR is in fact, the smallest form of debt ratios. The big brother is debt ratio which measures the total debts against the total assets. The equation is:

  • Total debt / Total assets.

The debt ratio gives us the big picture about the company’s debts and the proportion it bears to the total assets.

There is also one more ratio called the debt equity ratio which measures the amount of debt in relation to the total equity share capital. Debt equity ratio is calculated as follows:

  • Debt / equity

A high debt equity ratio shows that the company has larger amount of debts and hence the risk of running into financial difficulties is much more.

That’s about debt ratios …

…. have a nice day !!

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