# How to Calculate Interest Coverage Ratio?

The debt ratio which helps the company/ investors to determine how easily the interest is paid on a certain debt is known as Interest Coverage Ratio. It is also considered to be a profitability ratio by some financial experts. Interest coverage ratio is calculated by dividing EBIT (Earnings before Interest and Taxes) over a certain period of time by the amount that needs to be paid by the company as interest for that period.

Interest Coverage Ratio = EBIT/ interest expense

Or

Interest Coverage Ratio = (net earnings before extraordinary items- equity income + minority interest in the earnings of subsidiary companies + all income taxes + total interest charges)/ total interest charges

This ratio is also called as ‘times interest earned’

Interpretation of Interest Coverage Ratio

Interest is levied on debt which needs to be repaid timely in order to avoid proceedings and accumulations, both of which are not good for any company. Hence the company is more worried about it and Interest Coverage Ratio helps one to know that over how many times a company is capable to pay its interest outstanding with the available income.

The ratio depicts the margin of safety for the company as far as the interest payment is concerned. A firm’s higher Interest Coverage Ratio also depicts financial solvency, which plays an important role in share prices.

For example, if a company has earnings of 10 lakh in first quarter of 2016-17 with an outstanding interest payment of 20000 per month, the Interest Coverage Ratio will be calculated by dividing earnings by interest payment after rationalizing them to quarter from month. Interest Coverage Ratio = 10, 00,000/ (20,000*3) = 16.667 times.

Analysis of Interest Coverage Ratio

A company with lower Interest Coverage Ratio is likely to have debt expenses burden. A thumb rule considers 1.5 to be last acceptable value for this ratio, however, any number below this can be questionable and is likely to make lenders lose faith on the company due to which they can refuse further lending

If a company has Interest Coverage Ratio of 1 or below 1 is clearly not generating sufficient revenues which can meet interest expenses. In such a case the company needs more funds for which cash reserve can be used or a new sum needs to be borrowed. The company in such a case is very near to the event of bankruptcy. As a general practice, 2.5 are taken to be warning signal.