Interest Coverage Ratio – Explained with Example

What is the importance of the term “Interest Coverage Ratio” of a firm?

Banks and Companies are two highly interlinked entities.

The loans given by banks is often necessary for the growth of companies.

However, giving loans is a high-risk activity as far as banks are concerned.

Financial institutions like banks always check the ability of the corporate firms to repay the debt before sanctioning the loan.

Banks use different parameters to distinguish ‘strong’ firms from ‘weak’ firms.

One such parameter is the Interest Coverage Ratio.

What is Interest Coverage Ratio?

The interest coverage ratio is a debt and profitability ratio used to determine how easily a firm can pay or cover the interest on its outstanding debt.

This ratio measures how many times a company can cover its current interest payment with its available earnings.

In simple terms, the interest coverage ratio of a firm is the ratio of a firm’s profit after tax to its interest expense.

However, the interest coverage ratio is also expressed with respect to profit before interest and tax as well.

In such cases, the interest coverage ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expense during a given period.

Interest Coverage Ratio: Explained with an example

Consider a company names XYZ.

XYZ company’s earnings before taxes and interest are Rs. 10,00,000.

Its total interest payment requirements are Rs. 5,00,000.

Then the interest coverage ratio of firm XYZ is 2

ie Rs. 10,00,000/$Rs. 5,00,000.

Optimal Interest Coverage Ratio

There is no universally accepted optimal interest coverage ratio.

The value not only may vary between industries but also between companies in the same industry.

A firm with interest coverage of at least 2 is generally preferred.

There are many healthy and highly productive companies with an interest coverage ratio above 10.

A coverage ratio below 1 indicates the firm cannot meet its current interest payment obligations. It shows the underperformance and poor financial health of the company.

Also read: LIBOR (London Interbank Offered Rate)

What is the significance of the Interest Coverage Ratio?

Companies need to have good profits to cover interest payments.

A high-Interest Coverage Ratio is advised to meet its interest obligations and in order to survive future financial hardships (that may arise).

If a company has a low-interest coverage ratio, there’s a high chance that the company won’t be able to service its debt. This will put the firm at risk of insolvency or bankruptcy.

Firms with an interest coverage ratio lower than one are unable to meet their interest obligations from their income. Such firms are categorized as zombies.

Unproductive firms popularly referred to as “zombies” are typically identified using the interest coverage ratio.

Significance of Interest Coverage Ratio with respect to Indian Companies and Banking System

The Indian Banking system is recently criticized for the loans given to companies that repeatedly fail to pay back interest or principal.

Upon studying the interest coverage ratio of various companies, it is clear that banks gave loans to zombies without much consideration leading to the Non-Performing Asset (NPA) or bad loan crisis.

Economic Survey 2020-2021 points out that the share of new loans to zombie firms increased from 5% in 2007-08 to a whopping 27% in 2014-15.

The share of new loans sanctioned to zombie firms whose interest coverage ratio lies in the bottom quartile is found to increase from 20% in 2007-08 to 43% in 2014-15.

However, as the Twin Balance Sheet problem became a major news item, the Reserve Bank of India took strict measures to address the Non-Performing Assets issue. Now the share of new loans to zombie firms has started to decline.

Also read: Monetary Policy of India – Everything You Should Know About

UPSC Question on Interest Coverage Ratio

Qn 2020) What is the importance of the term “Interest Coverage Ratio” of a firm in India?

1. It helps in understanding the present risk of a firm that a bank is going to give a loan to.
2. It helps in evaluating the emerging risk of a firm that a bank is going to give a loan to.
3. The higher a borrowing firm’s level of Interest Coverage Ratio, the worse is its ability to service its debt.

Select the correct answer using the code given below:

(a) 1 and 2 only

(b) 2 only

(c) 1 and 3 only

(d) 1, 2 and 3

Answer: (a) 1 and 2 only