A firm's interest coverage ratio reflects how easily the firm can service its interest expenses on its outstanding debt. A high-interest coverage ratio means the firm can comfortably service its debt, while a lower ratio means it is under greater pressure to meet repayments. The interest coverage ratio is calculated using the following formula:
Earnings before interest and taxes/ interest expense
The amount of debt which a firm should generally take on and the 'acceptable' interest coverage ratio depends on a number of crucial factors. These include:
- The cyclical nature of the industry: Firms which operate in industries that are highly cyclical, for example, the auto-industry/industrial goods may have a harder time serving their short-term debt during times of sustained economic downturn. Consequently, it is generally advisable that these firms take on lower levels of debt and have more manageable interest coverage ratios.
- The industry in which the firm operates: Certain industries such as the oil & gas sector have very high costs at the beginning, which gradually decrease as operations are set up. This is because large costs are often incurred with exploration, pipelines built for transport and opening refineries. However, costs decrease dramatically once operations are in 'full swing'. For these firms, the interest coverage ratio generally starts off low and increases gradually.
- The size of the firm: Larger firms do not generally require large amounts of debt to grow their operations. They usually have large cash reserves/are generating regular cash flow. Larger firms are also usually at a more mature stage in the business cycle. On the other hand, smaller firms may require taking on larger amounts of debt to promote their products and grow their business. Borrowing rates may also be higher for smaller firms. As a consequence, their interest coverage ratios may be higher and gradually decrease over time.
It is crucial for a firm to meet its short-term borrowing obligations. Not being able to service its debt may even put a very high-quality firm out of business, simply as a result of a short-term downturn. It is, therefore, crucial to undertake an in-depth analysis of the firm's interest coverage ratio and determine whether or not it is appropriate, depending on the sector it operates/the requirements and size of the firm.
