Question

Hi Max. Thanks for sharing this great example! Excessive levels of debt can definitely be a red flag. While the company may have legitimate reasons for selecting debt financing over equity financing, too much debt can paralyze the company as they may fall into violation of their debt covenants and have difficulty meeting their financial obligations. Class, how might the interest coverage ratio be telling in this type of situation?

Answer 1

The interest coverage ratio falls under the category of debt ratios. It is a ratio which measures the company's ability to pay interest on its debt in a timely manner. It does not deal with principal re-payments, but rather only with the interest component.

Interest coverage ratio can be calculated in 2 ways:

EBIT(Earnings before interest and tax) / Interest payments for the same period.

Cash flow from operation / Interest payments for the same period.

Hence, the lower the interest coverage ratio, the more difficult it is for the company to service its interest payments based on its earnings/cash flow. The ratio in an indicator of how well the company can use its earnings to service debt. A ratio of lower than 1.5 puts serious doubts on the ability of the company to pay its interest.

This ratio is important for the companys shareholders and creditors. They use this ratio to determine whether the company has enough earnings to support its interest expenses. If this ratio is too high, it means that the company is barely able to service its existing debt obligations, so new creditors would be averse to lend more money to such a company. Usually, the company's trend of interest coverage ratio over a period of time is considered by financial institutions before lending money to it.

This ratio can also be laid down as one of the positive debt covenants used by financial institutions at the time of dispering debts. For example, a borrower borrows a certain sum of money from a lender. The lender can down the following debt covenant: the borrower must maintain an interest coverage ratio of 3.5, based on cash flow from operations. This will provide a security to the lending institution that the company maintains enough cash flow so that the payments of interest are not hampered