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Interest Coverage Ratio

Interest Coverage Ratio Assignment / Homework Help
Interest Coverage ratio is one of the measures of a firmís ability to handle financial burdens. It is also referred to as times interest coverage ratio. The ratio tells us how many times the firm can cover or meet the interest payments associated with debt. It indicates the firmís ability to meet or honor interest obligations on debt. It is computed as:

EBIT
Interest Expense

EBIT stands for 'Earnings Before Interest and Taxes'

Earnings before interest and taxes are used in the numerator of this ratio because the ability of the company to pay interest is not affected by tax burden as interest is tax deductible expense. The ratio indicates the extent to which earnings may fall without causing any embarrassment to the firm regarding the payment of interest charges. The higher the coverage ratio, the greater is the ability of the firm to meet its interest obligations. An interest coverage ratio of three times indicates that the firm is able to generate earning three times greater than its interest payments. Coverage of less than one does not augur well for the company as it indicates that the firm is not generating enough income to service its debt obligations. It may be a sign of company carrying excessive debt or operating inefficiently.

Example:
    Year 2009
EBIT $654,900
Interest expense $95,450

Debt-Equity ratio: $654,900
$95,450

=> 6.86 times

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