# Interest Coverage Ratio Formula How It Works and Example

## Interest Coverage Ratio Formula

The interest coverage ratio is a financial ratio that measures a company’s ability to pay its interest expenses on outstanding debt. It is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expenses. The formula for calculating the interest coverage ratio is as follows:

### Interest Coverage Ratio Formula:

Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expenses

The interest coverage ratio is an important metric for investors and creditors as it indicates the company’s ability to meet its interest obligations. A higher interest coverage ratio suggests that the company is more capable of paying its interest expenses, while a lower ratio may indicate financial distress and a higher risk of defaulting on its debt.

For example, let’s say Company XYZ has an EBIT of \$500,000 and interest expenses of \$100,000. Using the formula, we can calculate the interest coverage ratio as follows:

EBIT Interest Expenses Interest Coverage Ratio
\$500,000 \$100,000 5.0

Overall, the interest coverage ratio is a useful tool for investors and creditors to assess a company’s financial health and its ability to service its debt. It provides insight into the company’s profitability and risk profile, helping stakeholders make informed decisions about their investments or lending.

## How It Works and Example

The interest coverage ratio is a financial metric that measures a company’s ability to pay its interest expenses on outstanding debt. It is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expenses. The resulting ratio indicates the number of times a company can cover its interest expenses with its earnings.

A higher interest coverage ratio indicates that a company is more capable of meeting its interest obligations, as it has a larger buffer to cover its interest expenses. Conversely, a lower interest coverage ratio suggests that a company may have difficulty meeting its interest payments, which could be a sign of financial distress.

For example, let’s say Company A has an EBIT of \$1,000,000 and interest expenses of \$200,000. The interest coverage ratio would be calculated as follows:

Interest Coverage Ratio = EBIT / Interest Expenses

Interest Coverage Ratio = \$1,000,000 / \$200,000

Interest Coverage Ratio = 5

This means that Company A’s earnings are five times higher than its interest expenses. This indicates that the company is in a strong financial position and is likely able to comfortably meet its interest obligations.