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Interest coverage ratio

The interest coverage ratio. What is it, how do you calculate it, what are its uses and limitations? The interest coverage ratio is a financial ratio that attempts to measure how easily a company can pay its interest expenses on outstanding debt. The key word in this sentence is “attempt”, as it is not always successful in achieving its goal. ⏱️TIMESTAMPS⏱️ 0:00 Introduction to interest coverage ratio 0:09 Interest coverage ratio definition 0:27 Interest coverage ratio formula 1:03 Interest coverage ratio meaning 2:25 Interest coverage ratio example: Home Depot 3:08 Interest coverage ratio example: McDonald's 3:44 Interest coverage ratio example: Apple 4:30 Interest coverage ratio example: Boeing 5:19 Interest coverage ratio example: Tesla 5:42 Interest coverage ratio example: Verizon 7:12 When to use the interest coverage ratio The formula for the interest coverage ratio is Operating Income (or a variation thereof) divided by interest expense. Both of these can be found in the income statement. The amount of interest expense is a function of the amount of outstanding debt that a company has, and the interest rate that the company pays on that debt. With Operating Income in the numerator, and interest expense in the denominator, another name for the interest coverage ratio is “times interest earned”. As in: how many times the interest do you earn in Operating Income. If the interest coverage ratio is 10, then that means that for every $ of interest expense, there is $10 of Operating Income to cover it. If the interest coverage ratio is 2, then that means that for every $ of interest expense, there is only $2 of Operating Income to cover it, and you are much more fragile to either a decrease in Operating Income or an increase in interest expense. We will see how this works in upcoming examples. In general, the higher the interest coverage ratio, the more likely a company is to be able to make its interest payments, which should comfort lenders, creditors and shareholders about the long term viability of the company. Let’s see if we can calculate the interest coverage ratios for each of the years of a three year period for the following companies: Apple, Boeing, Home Depot, McDonald’s, Tesla and Verizon. For how many of these companies can you successfully calculate the interest coverage ratio for 2017, 2018 and 2019? The answer to that question is: only two out of the six! Let me show you, and explain you why you can or can’t! Home Depot. Let’s take the consolidated statement of earnings, locate the lines for Operating Income and for interest expense, and then divide. The interest coverage ratio was 13 for fiscal year 2019, 15 for fiscal year 2018, and 14 for fiscal year 2017. For every $ of interest expense, in the past couple of years, there was between $13 and $15 of Operating Income to (easily) cover it. As there was sufficient Operating Income to cover interest expense, there are enough earnings left to cover taxes and Net Income. McDonald’s. Take the consolidated statement of income, locate the lines for Operating Income and for interest expense, and then divide. The interest coverage ratio was 8 for 2019, down from 9 for 2018, and 10 for 2017. For every $ of interest expense, there was between $8 and $10 of Operating Income to (easily) cover it. Interest coverage ratio. Operating Income divided by interest expense, assuming that Operating Income is positive, and assuming that the company you review actually has any interest expense. For mature and profitable companies, with no unusual items in their financial statements, and more debt than interest-earning assets on the balance sheet, this can be a meaningful metric to measure how easily a company can pay its interest expenses on outstanding debt. For companies outside that category, there are far more meaningful financial ratios we can use! Philip de Vroe (The Finance Storyteller) aims to make accounting, finance and investing enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better investing decisions. Philip delivers #financetraining in various formats: YouTube videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!