Definition
Interest Coverage Ratio, also known as Times Interest Earned Ratio (TIE), states the number of times a company is capable of bearing its interest expense obligation out of the operating profits earned during a period.
Formula
|
Interest Cover Ratio |
= |
Profit before interest and tax (PIBT) |
|
Interest Expense |
||
Explanation
Interest Coverage Ratio indicates the capacity of an organization to pay its interest obligations. An interest cover of 2 implies that the entity has sufficient profitability to bear twice the amount of its current finance cost.
The effect of taxation is normally ignored in the interest cover calculation to facilitate a better comparison of the contribution of the company’s underlying profitability towards meeting its interest obligations which may be blurred to an extent by the effects of revision in tax rates, policies and prior period tax adjustments over several accounting periods.
Example
ABC PLC has the following financial results for the year ended 31st December 2012:
| $m | |
|---|---|
|
Sales |
200 |
|
Cost of Sales |
(110) |
|
Gross Profit |
90 |
|
General and administration |
(20) |
|
Finance cost (Note 1) |
(30) |
|
Profit before tax |
40 |
|
Taxation |
(10) |
|
Profit after tax |
30 |
Note 1: Finance Cost
Finance cost comprises the following expenses:
| $m | |
|---|---|
|
Bank Charges |
5 |
|
Unwinding of discount on provisions |
5 |
|
Interest cost on short term and long term borrowings |
20 |
|
Total |
30 |
Interest Coverage may be calculated as follows:
|
Interest Cover Ratio |
= |
Profit before interest and tax (PIBT) |
|
Interest Expense |
||
|
= |
40 + 30 |
= |
3 times |
|
20* |
|||
*Interest cost used in calculating interest coverage includes only the interest expense incurred on loans and other financing arrangements but does not include accounting expense recognized in respect of unwinding of discount on the recalculation of present value of provisions.
Interpretation & Analysis
Loans and borrowings are cheap source of finance primarily because the interest cost is usually tax deductible in most jurisdictions unlike dividend payments. However, interest costs are obligatory payments unlike dividend payouts which are discretionary upon management’s intent. Therefore, the level of debt financing must be at an acceptable level and should not exceed the point which exposes an organization to unacceptably high financial risk as might be reflected in a low interest cover.
Generally, companies would aim to maintain an interest coverage of at least 2 times. Interest cover of lower than 1.5 times may suggest that fluctuations in profitability could potentially make the organization vulnerable to delays in interest payments.
A very high interest cover may suggest the fact that the company is not capitalizing on the relatively cheaper source of finance (i.e. debt) and in such instances an increase in gearing ratio may actually add value to the enterprise.
Companies operating in industries that are exposed to a high level of business risk and uncertainty would generally prefer to maintain lower level of financial risk (by lower debt financing) and higher interest cover ratios. Most IT related startup companies prefer equity financing through venture capital institutions rather than loan financing due to the high level of risk involved and such companies would tend to have very high interest coverage ratios.
When analyzing interest coverage trend over several accounting periods, it is important to consider significant changes in the level of borrowings since the full extent of such changes on future interest cover may not be entirely revealed due to the effect of additional borrowings or repayments of loans close to end of accounting periods.
Importance
Interest Coverage Ratio is a measure of the capacity of an organization to honor it interest obligations.
Interest coverage is an indication of the margin of safety for an organization before it runs the risk of non-payment of interest cost which could potentially threaten its solvency. Although profitability is not absolutely essential to maintain liquidity in the short term, profitability of operations is crucial to enable an organization to meet its debt servicing obligations in the long run. Management may also use interest cover ratio to determine whether further debt financing can be undertaken without taking unacceptably high financial risk.
Potential lenders and investors assess the interest cover ratio to determine the level of security and risk associated with their investment or lending to the organization. Interest cover ratio is also a regular feature of loan covenants requiring borrowers to maintain a minimum level of interest cover failing which may impose the immediate settlement of debt.