Interest coverage ratio indicates whether the business is able to cope with its debt obligation, i.e. whether the business earns enough operating profit to be able to pay interest on borrowed financial means.
Interest Coverage Ratio Formula
The following interest coverage ratio formula is used:
Interest coverage ratio indicates, how many times Earnings before Interest and Tax (EBIT) can cover interest expenses of the business for the borrowed financial means.
The rule is that the business must be able to generate sufficient profits from its main activities to be able to meet its financial liabilities.
All the data for this ratio calculation can be derived from the Income Statement.
The result of interest coverage ratio will be expressed in times, not percentage and will indicate how many times EBIT covers interest expenses.
Interest Coverage Ratio = Times Interest Earned Ratio
Also how to calculate interest coverage ratio you can see here – times interest earned ratio, since this is the other way how this ratio is being called.
Also what is essential to understand that EBIT from the Income Statement is obtained by using accrual accounting method, which would mean that revenues are recognized while earned and expenses are recognized if they are related to the revenues earned, without taking into account the actual receipt or spending of cash.
Therefore to see the full picture of the business ability to generate enough cash to pay its financial debts, it is recommended to analyse cash flow statement also and check whether the business generates enough cash from operating activities.
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