Interest Coverage Ratio is a type of Solvency Ratio that determines a company’s capacity to pay its Interests. It is a measure of the profitability of a company relative to the interest payable. Interest Coverage Ratio is also known as Times-Interest Earned Ratio.
$$Interest\quad Coverage\quad Ratio=$$$$\frac { EBIT }{ Interest\quad Expense } $$
EBIT is Earnings Before Interest and Taxes or the Gross earning of a company
Where,
$$Interest\quad Coverage\quad Ratio=$$$$\frac { EBIT }{ Interest\quad Expense } $$
EBIT is Earnings Before Interest and Taxes or the Gross earning of a company
Where,
- And Interest Expense implies Total Interest Payable by a Company.
Significance and Interpretation
- Interest Coverage Ratio = 1: This implies that the gross profit of the company is just equal to the interest payable, this is an alarming situation for the company.
- Interest Coverage Ratio < 1: This implies that the gross profit of the company is not even enough to pay the interest dues, such companies are on the verge of getting insolvent.
- Interest Coverage Ratio> 1: This implies that the company’s gross profit is more than its interest payable, this seems to be good, but it is not enough for the company to grow and survive.
- The ideal Interest Coverage Ratio is > 3, below which it is not considered to be safe. However, for some industries, the Interest Coverage Ratio of 2-3 may be acceptable. It must be noted that this limit may shift depending upon the regulatory reforms and/or type of business.
Examples
Example 1:
Earnings before Interest and taxes (EBIT) for M/S XYZ Ltd. is ₹5050 Crores, total debt is ₹4500 Crores on which interest is applicable at the rate of 10%. Calculate the Interest Coverage Ratio for M/S XYZ Ltd.
Solution:
EBIT = ₹5050 Crores
Total Interest = 10% of ₹4500 Crores
Total Interest = 10% of ₹4500 Crores
⇨ ₹450 Crores
Interest Coverage Ratio = EBIT / Total Interest
Interest Coverage Ratio = EBIT / Total Interest
⇨ 5050/450
⇨ 101/9
Hence, Interest Coverage Ratio = 101/9 = 11.22
Hence, Interest Coverage Ratio = 101/9 = 11.22
Example 2:
Profit after taxes for M/S ABC Ltd is ₹560 Crores, the rate of tax is 30% for companies. Total debt for the company is ₹750 Crores on which interest is applicable at a rate of 12%. Calculate the Interest Coverage Ratio for M/S ABC Ltd.
x- 30% of x = Profit After Taxes
Therefore, 7x/10
Solution:
Let Earnings/Profit before taxes be x, then as given:x- 30% of x = Profit After Taxes
Therefore, 7x/10
⇨ 560
Hence, x = 800.
Hence, x = 800.
Hence Earning Before Taxes= ₹800 Crores
Total Interest = 12% of 750 Crores
Total Interest = 12% of 750 Crores
⇨ ₹90 Crores
Earnings Before Interest + Taxes = Earnings Before Taxes + Interest
Earnings Before Interest + Taxes = Earnings Before Taxes + Interest
⇨ 800 + 90
⇨ ₹890 Crores
Interest Coverage Ratio = EBIT / Total Interest
Interest Coverage Ratio = EBIT / Total Interest
⇨ 890/90
⇨ 89/9
Hence, Interest Coverage Ratio = 89/9 or 9.89
Hence, Interest Coverage Ratio = 89/9 or 9.89
