Interest cover

3 key takeaways

• Interest cover helps determine if a company earns enough to meet its interest payments on debt.
• A higher interest cover ratio indicates a better ability to pay interest, suggesting lower financial risk.
• Investors and lenders use this ratio to assess a company’s financial health and stability.

What is interest cover?

Interest cover, also known as the interest coverage ratio, is a financial metric that shows how easily a company can pay the interest on its debt with the money it makes from its regular business operations (before paying taxes and interest).

Importance of interest cover

• Financial Health: It indicates whether a company is making enough money to cover its interest expenses.
• Risk Assessment: A high ratio suggests the company is at lower risk of defaulting on its debt, while a low ratio indicates potential trouble in meeting interest payments.
• Creditworthiness: Lenders and investors look at this ratio to decide if a company is a safe bet for loans or investments.

How to understand interest cover

• High Ratio: If the ratio is 3 or higher, it means the company can pay its interest expenses three times over, which is generally considered healthy.
• Moderate Ratio: A ratio between 1.5 and 3 means the company can pay its interest, but it doesn’t have much extra cushion.
• Low Ratio: A ratio below 1.5 is a warning sign that the company might struggle to meet its interest payments.

Example of interest cover in practice

Imagine a company that earns $500,000 from its operations in a year, and it needs to pay $100,000 in interest on its debt. The interest cover ratio is calculated by dividing the earnings by the interest expense. In this case, the company can cover its interest payments five times over ($500,000 divided by $100,000 equals 5). This indicates good financial health.

Factors affecting interest cover

• Revenue: Higher sales and revenue improve the ratio because the company earns more money.
• Debt Levels: More debt means higher interest expenses, which can lower the ratio.
• Interest Rates: If interest rates go up, the company’s interest payments increase, which can lower the ratio.
• Efficiency: Better management of operations to reduce costs can improve the ratio by increasing earnings.

Improving interest cover

Companies can improve their interest cover ratio by:

• Increasing Sales: Boosting revenue through better marketing or expanding into new markets.
• Cost Reduction: Cutting unnecessary expenses to increase earnings.
• Debt Management: Paying off debt or refinancing at lower interest rates to reduce interest expenses.
• Asset Management: Using company assets more efficiently to generate higher returns.

By understanding and managing their interest cover ratio, companies can ensure they are better positioned to meet their financial obligations and maintain stability. This helps them gain the confidence of investors and lenders, supporting their growth and operations.