As per debt statistics for India, repayment has taken a significant dip after demonetization. A lot of companies have defaulted on interest payments, leaving a huge amount of unsecured debt.
The interest coverage ratio is considered the primary metric for assessing a company’s financial health. A ratio of 2 indicates adequate financial condition, while a ratio of less than 1 means poor condition. A higher ratio indicates a greater profit potential.
Banks’ interest coverage ratio is considered an indicator of sound financial condition. For banks, the ratio is measured as (annual interest expense – annual interest income).
Furthermore, the bank’s interest coverage ratio will normally increase as the bank grows in size.
What does it mean to have a high interest coverage ratio?
The interest coverage ratio shows whether a company generates enough money to pay back the principal of a loan. It is the ratio of a company’s cash flow (defined as sales minus the cost of servicing debt, interest, and income taxes) to its total interest payments.
It also measures how efficient a company is at collecting its funds and how long it can pay interest on the debt. For example, a company with an interest coverage ratio of 3.5 has a cash flow of $3.5 million, and it can generate $2.5 million (50% of its sales) in free cash flow or enough funds to pay off $1 million of debt.
On the other hand, a company with an interest coverage ratio of 2.5 has a cash flow of $2.5 million, and it can generate $1.5 million (30% of sales) in free cash flow, enough funds to pay off $750,000 (30% of the debt).
Note that a company running a negative interest coverage ratio means that it is not generating that much cash to pay off the principal of its loan.
A high interest coverage ratio is also very favorable for shareholders. A high-interest coverage ratio indicates that a company can continue to pay interest and pay other expenses for a long period.
What does it mean to have a low interest coverage ratio?
A low interest coverage ratio indicates that a company cannot generate enough cash to pay its debt service. It means that a company is in danger of being unable to make timely debt service payments, and it might need to borrow additional funds to do so.
A low interest coverage ratio is also detrimental to shareholders.
If you’re an old school or a new investor in the financial market, you need to know what interest coverage ratio is all about. And most importantly, what it means for you when you enter the market. Both external and internal members of the company are needed to have this knowledge with them. To come to your rescue, we have provided this short but detailed overview of the interest coverage ratio. So get started if you haven’t already!