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Lesson 10: Solvency Ratios, Interest Cover Ratio

Solvency Ratios, Interest Cover Ratio

Solvency Ratios: Interest Cover RatioToday we will see a new Solvency Ratio, The Interest Cover Ratio, also known as Time Interest Earned (TIE). It establishes the relationship between the amount of net profit before deduction of interest and tax and the fixed interest charges. The Interest Cover Ratio indicates the company’s ability to pay interest on its outstanding debt and to what extent operating income can decline before the company is unable to meet its annual interest expenses.

The lower the ratio, the higher the likelihood that the company will not be able to service its debt (pay interest expenses on its debt). If the interest coverage ratio gets below 1, the company is not generating enough earnings to service its debt.

With Interest Coverage Ratios, it is important to analyse them during good and lean years. Most companies will show solid interest coverage during strong economic cycles, but interest coverage may deteriorate quickly during economic downturns.

It is determined by dividing the operating profits or Earnings Before Interest and Taxes (EBIT) by the fixed interest charges on loans, as shown below.

Interest Cover Ratio, Solvency Ratios, Fundamental Analysis

 

It should be noted that this ratio uses the concept of net profits before taxes because interest is tax-deductible so that tax is calculated after paying interest on the long-term loan. This ratio, as the name suggests, indicates the extent to which a fall in EBIT is tolerable in that the ability of the firm to service its interest payments would not be adversely affected.

 

Example

A Company has earnings before interest and taxes (EBIT) in the amount of $ 80,000 and interest expenses in the amount of $ 7,000. This gives an interest coverage ratio in the amount of 11.42, which means that the company has the earnings more than 11 times its interest expense. 

Interest Cover Ratio, Solvency Ratios, Fundamental Analysis

 

An Interest Cover Ratio of 11.42 provides sufficient coverage that the company will be able to service its debt.

In the next article, we will start to see the first Profitability Ratio.

 

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