Investing coverage ratio

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For established companies in certain industries, such as a utility company, an interest coverage ratio of two is often an acceptable standard. A well-established utility will likely have consistent production and revenue, particularly due to government regulations, so even with a relatively low-interest coverage ratio, it may be able to reliably cover its interest payments.

Other industries, such as manufacturing, are much more volatile and may often have a higher minimum acceptable interest coverage ratio of three or higher. These kinds of companies generally see greater fluctuation in business. For example, during the recession of , car sales dropped substantially, hurting the auto manufacturing industry. Because these industries are more prone to these fluctuations, they must rely on a greater ability to cover their interest in order to account for periods of low earnings.

Because of such wide variations across industries, a company's ratio should be evaluated to others in the same industry—and, ideally, those who have similar business models and revenue numbers. Furthermore, while all debt is important to take into account when calculating the interest coverage ratio, companies may choose to isolate or exclude certain types of debt in their interest coverage ratio calculations.

The interest coverage ratio measures a company's ability to handle its outstanding debt. It is one of a number of debt ratios that can be used to evaluate a company's financial condition. The term "coverage" refers to the length of time—ordinarily, the number of fiscal years —for which interest payments can be made with the company's currently available earnings.

In simpler terms, it represents how many times the company can pay its obligations using its earnings. The ratio is calculated by dividing EBIT or some variation thereof by interest on debt expenses the cost of borrowed funding during a given period, usually annually. A ratio above one indicates that a company can service the interest on its debts using its earnings or has shown the ability to maintain revenues at a fairly consistent level.

While an interest coverage ratio of 1. For companies with historically more volatile revenues, the interest coverage ratio may not be considered good unless it is well above three. A bad interest coverage ratio is any number below one as this means that the company's current earnings are insufficient to service its outstanding debt. The chances of a company being able to continue to meet its interest expenses on an ongoing basis are still doubtful even with an interest coverage ratio below 1.

Article Sources Investopedia requires writers to use primary sources to support their work. Creditors want to know whether a company will be able to pay back its debt. If it has trouble doing so, there's less of a likelihood that future creditors will want to extend it any credit. Similarly, both shareholders and investors can also use this ratio to make decisions about their investments. A company that can't pay back its debt means it will not grow. Most investors may not want to put their money into a company that isn't financially sound.

Types of Interest Coverage Ratio There are a few different types of interest coverage ratios. Each serves a different purpose. This is calculated by dividing the total interest expense by a company's EBIT. But this isn't always a hard-and-fast rule.

That's because this characteristic can be fairly fluid to some degree. Higher ratios are better for companies and industries that are susceptible to volatility. But lower coverage ratios are often suitable for companies that fall in certain industries, including those that are heavily regulated.

As such, don't compare companies that aren't in the same industry. For instance, it's not useful to compare a utility company which normally has a low coverage ratio with a retail store. The interest coverage ratio is a financial metric that measures whether companies can pay their outstanding debts. The general rule is that the higher the ratio, the better position a company has to repay its interest obligations while lower ratios point to financial instability.

Analysts generally look for ratios of at least two 2 while three 3 or more is preferred. A ratio of one 1 is not good. A company's interest coverage ratio can be negative. When this happens, it is under one 1. Companies that find themselves in this situation are not considered financially healthy. As such, they aren't able to keep up with their financial obligations. The simple way to calculate a company's interest coverage ratio is by dividing its EBIT the earnings before interest and taxes by the total interest owing on all of its debts.

The Bottom Line There are many metrics that can help you determine the financial health and well-being of companies and, therefore, your investment portfolio. One of those is the interest coverage ratio. This figure measures a company's ability to cover its interest obligations.

Knowing how to calculate it and using it with other valuable financial metrics can help you become a well-informed investor so you can make better decisions about your investments. Article Sources Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate.

You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.

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