Interest coverage is a financial indicator that shows a company’s ability to cover its interest costs. It is calculated by dividing earnings before interest and taxes by the amount of interest. A ratio of 1.5 or higher is recommended, and investors use this ratio along with other factors to make decisions about buying or selling shares.
Interest coverage is a ratio that can be used as a financial indicator. It communicates the ability of a company to cover the interest costs of its debts during a given period. Investors often use this ratio to make decisions about buying or selling shares, and it is expressed as a number. The lower the number, the higher the risk associated with a business. The 1.5 ratio is recommended as a good minimum standard.
Interest is a recurring expense for many businesses. It’s a fee assessed for borrowing money, and interest coverage is an indication of a company’s ability to cover those costs. This relationship is one of the factors that some investors consider when determining whether to buy or sell shares of a company. Investors are often hesitant to put money into companies that appear to be having trouble meeting their financial obligations.
Interest coverage is commonly calculated by determining a company’s earnings for a specified period and dividing the amount of its interest obligations for the same period. This more common method of calculating interest coverage is often referred to as EBIT, which stands for earnings before interest and taxes. EBIT is the same as net earnings, and it serves as the numerator in the equation. The amount of interest serves as the denominator, and the result is the ratio that informs an investor of the company’s ability to make interest payments.
The number produced from this equation communicates how many times a company can pay its interest obligations with available earnings. Interest coverage is often expressed as a single digit number. For example, two would suggest that a company could make interest payments twice its current income. A negative number indicates that a company cannot meet these obligations and is likely to experience financial difficulties.
Low interest coverage for a particular period may not be a reliable indication of a company’s financial standing or the risk an investor faces. As earnings fluctuate, interest coverage can also fluctuate, leading many people to assess a company’s ability to pay interest over a period of time. An investor can look back months or years, depending on his strategy. It is important for new investors to understand that this ratio is rarely used as the only factor on which a stock decision is based. Financial professionals also strongly recommend against owning a stock that has an interest coverage of less than 1.5.
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