Borrowing money is one of the most effective things a company can do to build its business. But, of course, borrowing comes with a cost: the interest that is payable month after month, year after year. These interest payments directly affect the company's profitability. For this reason, a company's ability to meet its interest obligations, an aspect of its solvency, is arguably one of the most important factors in the return to shareholders.

Interest Coverage

Interest coverage is a financial ratio that provides a quick picture of a company's ability to pay the interest charges on its debt. The "coverage" aspect of the ratio indicates how many times the interest could be paid from available earnings, thereby providing a sense of the safety margin a company has for paying its interest for any period. A company that sustains earnings well above its interest requirements is in an excellent position to weather possible financial storms. By contrast, a company that barely manages to cover its interest costs may easily fall into bankruptcy if its earnings suffer for even a single month.

Interest-Coverage Ratio

The formula for calculating the interest-coverage ratio is as follows:

To simplify this (and express the formula in terms of a figure widely reported for most large companies), we can say that we are simply using earnings before interest and taxes (EBIT) as the numerator of the formula. In other words, the interest-coverage ratio is calculated as follows:

Source : Investopedia

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