A company’s capacity to satisfy necessary payments (particularly, interest expenditure) tied to outstanding debt commitments on schedule is measured by its Interest Coverage Ratio. Interest coverage ratios come in a variety of shapes and sizes, but most credit analysts and lenders consider greater ratios to be signals of lower default risk.
Definition of the Interest Coverage Ratio
Leverage ratios, which measure how much debt constitutes the overall capital structure, are one approach to analyzing a company’s financial risk.
The amount of debt a corporation carries is compared to either:
- Debt-to-Equity Ratio (D/E), and Debt-to-Total Capitalization are examples of capital sources.
- Debt-to-EBITDA, Debt-to-EBIT, Debt-to-EBITDA, Debt-to-EBITDA CapEx is reduced.
Analysis of coverage ratios is another typical method for determining a company’s risk of default. Companies must track their interest expense payments in addition to the obligatory loan principle obligations due on the maturity date. It assesses a company’s capacity to make its scheduled interest commitments on time. The larger a company’s principal is, the more interest it will have to pay.
Coverage ratios, unlike leverage ratios, compare a cash flow statistic in the numerator that represents the company’s operational cash flow to the amount of interest expense in the denominator.
- EBITDA, EBIT, (EBITDA – CapEx) are all operating cash flow metrics.
Since D&A is brought back, EBITDA tends to produce the greatest value for an interest ratio, whereas EBITDA – CapEx is the most cautious.
The formula for Interest Coverage
The interest coverage ratio, as previously stated, divides a company’s operational cash flow statistic by the interest expense burden.
Coverage Ratio Formula
- Interest Coverage Ratio = EBIT / Interest Expense
Operating income (EBIT) is the most popular “middle ground” variant utilised in the calculation of interest coverage ratio, and it is typically what practitioners refer to when they say “interest ratio.”
It can be useful in determining if a company’s cash flows are sufficient to pay off the needed interest payments on its debt when lending to a potential borrower or supplying other types of financing.
Higher leverage ratios imply more financial risk, increasing the likelihood of the borrower defaulting on its needed loan payments.
In the case of interest ratios, however, the lower the figure, the riskier the borrower’s credit health — the polar opposite of leverage ratios.
Because there is more “cushion” in case the firm underperforms, the larger the number of “turns” for an interest coverage ratio, the more coverage (and lower risk).
Interest in Coverage Ratios by PIK
Interest expenditure may be paid in the form of “paid-in-kind” interest (or PIK interest) rather than cash interest under some loan arrangements.
The computed interest expense coverage ratios can be changed to exclude the consequences of any PIK interest in such circumstances. Because PIK is not a real cash outflow, just the cash element of interest charge should be included in the computation.
If all other factors are equal, PIK interest enhances interest ratios since it is not included in the “interest” line, but keep in mind that interest is still collecting on the loan principal and is due at maturity.
Example of EBITDA Interest Coverage Ratio Calculation
For example, if a company’s EBITDA is $100 million and its yearly interest expenditure is $20 million, its EBITDA interest ratio is 5.0x.
EBITDA Interest Coverage Ratio = $100 million minus $20 million = 5.0 times
The company’s EBITDA can service the $20 million in interest expenditure five times, implying that the company’s present interest payment can be paid for five “turns.”
However, if the EBITDA coverage ratio was substantially lower, say at 1.0x, even a minor downturn in the company’s performance may result in a default owing to a missed interest cost payment.
Excel Calculator for Interest Coverage Ratio
We may now exercise an example computation after discussing the purpose of interest cost ratios and the most common variations.
Assumptions for the Interest Coverage Ratio Model
To begin, we’ll create a set of model assumptions that we’ll utilise throughout the experiment.
Our example company’s financials as of Year 0, the first year of our estimates, are as follows.
Then, starting in Year 1, we’ll utilise a step function that anticipates each line item will increase by the following amount:
- EBITDA: Year 1 Growth Rate of 4.0 percent and Year 2 Growth Rate of +2.0 percent
- EBIT: 3.5 percent growth rate in the first year, with an annual increase of +1.5 percent.
- CapEx: 5.0 percent growth rate in the first year, with an annual increase of +2.0 percent.
- Total Interest Expense: –$2 million per year
By the end of Year 5, EBITDA had increased by 12.0% year-over-year (YoY), EBIT had increased by 9.5 percent, and CapEx had increased by 13.0%, demonstrating how the company’s operations are growing – however, the required reinvestments (i.e. CapEx) to fund the growth are also rapidly increasing in line with the EBITDA growth.
In contrast, the company’s total interest expense is decreasing from $30 million in Year 0 to $20 million by the end of Year 5, implying that the company’s debt principal is decreasing, which directly translates to lower interest expense because interest is a function of the outstanding debt principal.
Example of Interest Coverage Ratio Calculation
We can now compute the three primary variants of the interest ratio once all of the anticipated years have been filled out.
We’ll divide the relevant cash flow indicator by the total interest expenditure payable in that year for each change.
The coverage ratios change from Year 0 to Year 5:
- Interest Coverage Ratio: 2.0x 4.4x EBITDA
- 1.3x 2.7x EBIT Interest Coverage Ratio
- Interest Coverage Ratio: 1.2x – 2.5x (EBITDA – CapEx)
The EBITDA variation of the computed interest ratio is the largest, while the (EBITDA – CapEx) variation is the lowest, with the EBIT variation in the centre.