You’re thinking about buying an investment property. But before you do, you want to make sure it’s a wise investment that will generate enough income to cover ownership costs, including the mortgage payment. That’s where the interest coverage ratio comes in.
What Is Interest Coverage Ratio?
The interest coverage ratio, sometimes called the “debt service coverage ratio,” is a financial metric used to assess whether a company has sufficient earnings to cover its interest payments. A company with a high-interest coverage ratio is considered financially healthy because it has plenty of earnings to cover its debt payments. On the other hand, a company with a low-interest coverage ratio may have difficulty making its debt payments and is at risk of loan default.
How is Interest Coverage Ratio Calculated? Formula & Example
It is calculated by dividing EBITDA by Interest Expenses.
Interest Coverage Ratio = EBITDA/ interest expenses
EBITDA stands for Earning before Interest Tax, Depreciation, and Amortization
Or Another Formula is to divide EBIT by interest expenses:
Formula = EBIT/Interest expenses
For example, let’s say that a company has an EBIT of $1 million and interest expenses of $500,000. The company’s interest coverage ratio would be 2 ($1 million/$500,000), meaning it has enough earnings to cover its interest payments twice.
Why Is It Important?
The importance of the interest coverage ratio lies in its ability to predict a company’s ability to repay its debts. A high ratio indicates that a company is unlikely to default on its loans because it has plenty of earnings to make its debt payments. On the other hand, a low ratio suggests that a company may have difficulty repaying its debts and could be at risk of defaulting on its loans. For this reason, lenders often use the interest coverage ratio when considering loan applications.
How Can It Be Used?
In addition to being used by lenders, the interest coverage ratio can also be used by investors when evaluating potential investments. When looking at a company’s financial statements, investors often calculate the interest coverage ratio to get an idea of how risky investment might be. Companies with high ratios are generally considered less risky than those with low ratios because they are less likely to default on their loans.
Conclusion
The interest coverage ratio is a significant financial metric that can assess a company’s ability to repay its debts. It is calculated by dividing a company’s EBIT by its interest expenses for a given period and is expressed as a number. A high ratio indicates that a company is unlikely to default on its loans because it has plenty of earnings to make its debt payments; conversely, a low ratio suggests that a company may have difficulty repaying its debts and could be at risk of defaulting on them entirely.
In addition to being used by lenders when considering loan applications, investors often use the interest coverage ratio when assessing potential investments; companies with high ratios are usually considered less risky than those with low ratios from an investor standpoint because they have less chance of defaulting on their loans altogether.
