Interest Coverage Ratio

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 Coverage Ratio = EBIT / Interest Expense
Where,
  • EBIT is Earnings Before Interest and Taxes or the Gross earning of a company
  • 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 = ₹450 Crores
  • Interest Coverage Ratio = EBIT / Total Interest = 5050/450 = 101/9
  • 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.
  • 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 Earning Before Taxes= ₹800 Crores
  • Total Interest = 12% of 750 Crores = ₹90 Crores
  • Earnings Before Interest + Taxes = Earnings Before Taxes + Interest = 800 + 90 = ₹890 Crores
  • Interest Coverage Ratio = EBIT / Total Interest = 890/90 = 89/9
  • Hence, Interest Coverage Ratio = 89/9 or 9.89
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