Interest Cover is ratio between Net Profit Before Interest and TAX, and Interest. It compares Net Profit Before Interest and TAX with annual Interest.
What does Interest Cover measure?
Interest Cover measures how many times a business could pay its annual charges of Interest on the borrowed capital out of its Net Profit Before Interest and TAX.
Specifically, how well a business can pay the Interest due on outstanding debt – the burden of Interest payments on banks loans, mortgages and debentures. In general, the lower the Interest Coverage ratio, the higher the company’s debt burden.
Lenders such as banks as well as current and potential investors will use the Interest Cover ratio to determine how risky a company is in relation to its current debt or for any future borrowings.
Interest Cover is frequently used in conjunction with Gearing to judge the firm’s debt situation. When the firm’s Interest Cover ratio is 1.5 or lower, it might be challenging to meet Interest expenses, not to mention earn any profit for the owners.
Interest Cover measures how many times a business could pay Interest on the borrowed capital using Net Profit Before Interest and TAX.
How to calculate Interest Cover?
The figures for working out Interest Cover can be found in Profit and Loss Account (P&L Account):
| Net Profit Before Interest and TAX | |||
| Interest Cover = | ━━━━━━━━━━━━━━━━━━━━ | x 365 | |
| Interest |
Comment
Interest Cover is expressed in times as a number.
Interest Cover > 1. If Interest Cover is 2, it means that the company has USD$200 of Net Profit Before Interest and TAX to pay for USD$100 of Interest. The company has twice as much Net Profit Before Interest and TAX to pay Interest on its Long-term Liabilities including banks loans, mortgages and debentures. The higher Interest Cover is, the less risky the current borrowing levels are for the business.
Interest Cover = 1. If Interest Cover is 1, it means that all Net Profit Before Interest and TAX is being used to pay back Interest costs. This is bad news for the firm’s capital investment plans as the business will not have any Net Profit After Interest and TAX to keep as Retained Profit to reinvest back in the business for future growth. This is also bad news for current shareholders as there will be no Net Profit After Interest and TAX to pay out as a Dividend.
Interest Cover 0<>1. If Interest Cover is 0.5, it means that the company has USD$50 of Net Profit Before Interest and TAX to pay for USD$100 of Interest. The company has not enough of Net Profit Before Interest and TAX to pay Interest on its Long-term Liabilities. The lower the Interest Cover is, the riskier the current borrowing levels are. Any company with Interest Cover below one has trouble generating earnings needed to pay its interest obligations. The company has poor financial health which may increase the possibility of bankruptcy.
Interest Cover = 0. If Interest Cover is 0, it means that the company has no Net Profit Before Interest and TAX to pay for USD$100 of Interest. The company is not able to make any payments towards its Interest obligations.
Example for Interest Cover
COMPANY A
Company A has Net Profit Before Interest and TAX of USD$150,000 and Interest to pay on long-term borrowings of USD$120,000 in 2020. In 2021, Net Profit Before Interest and TAX was USD$240,000 and Interest to pay on long-term borrowings remained the same of USD$120,000.
| 2020 | 2021 | ||||||
|---|---|---|---|---|---|---|---|
| Net Profit Before Interest and TAX | $150,000 | $240,000 | |||||
| Interest | $120,000 | $120,000 | |||||
| Interest Cover | 1.3 | ➚ | 2.1 |
In 2020, Company A has Interest Cover of 1.3. It means that in 2021, the firm has more than enough of Net Profit Before Interest and TAX to pay Interest. The situation improved in 2021 as now the company has more than twice as much of Net Profit Before Interest and TAX to pay USD$120,000 of Interest. Company A has less of the burden of Interest payments on banks loans, mortgages and debentures.
How to improve Interest Cover?
Interest Cover of a business could be improved by lowering Interest payments. How to do that?
- Pay off some Long-term Liabilities. This can be done when the firm has large amounts of Cash in Balance sheet, or by issuing new shares to investors in exchange for cash. Settling a large debt can improve the Interest Cover ratio.
- Refinance long-term debt. Negotiate with the bank to replace its current debt with a lower interest rate debt. Obtaining low-cost, fixed-rate debt can be done by extending the loan period. Choosing loans with lower interest rates would improve the Interest Cover ratio.
The real problem facing Finance Managers is how much long-term debt the firm can handle before the benefits of business growth outweigh the costs of high Gearing and financial risks. The business needs to find a balance in financing streams between Debt Finance vs. Equity Finance.
