Times covered

3 key takeaways

• Times covered, or the interest coverage ratio, indicates how easily a company can pay interest on its debt from its operating earnings.
• A higher times covered ratio suggests a company is more capable of meeting its interest obligations, implying lower financial risk.
• The ratio is calculated by dividing earnings before interest and taxes (EBIT) by the interest expense.

What is times covered?

Times covered, commonly referred to as the interest coverage ratio, is a financial metric used to assess a company’s ability to pay interest on its outstanding debt. It is an important measure of financial health and stability, indicating whether a company generates enough earnings to cover its interest payments. The ratio helps investors, creditors, and analysts understand the risk associated with the company’s debt load and its ability to manage its debt obligations.

How to calculate times covered

The times covered ratio is calculated using the following formula:

Times Covered (Interest Coverage Ratio) = Earnings Before Interest and Taxes (EBIT) / Interest Expense

Example Calculation

Suppose a company has the following financials for a given period:

• Earnings Before Interest and Taxes (EBIT): $500,000
• Interest Expense: $100,000

The times covered ratio would be:

Times Covered = 500,000 / 100,000 = 5

This means the company’s earnings are five times greater than its interest obligations, indicating strong ability to meet its interest payments.

Importance of times covered

Understanding the times covered ratio is crucial for several reasons:

• Financial Health: It provides insight into a company’s financial stability and its ability to manage debt. A higher ratio indicates a stronger capacity to pay interest, while a lower ratio suggests potential difficulties.
• Risk Assessment: Investors and creditors use the ratio to evaluate the risk of lending to or investing in a company. Companies with higher interest coverage ratios are generally considered less risky.
• Operational Efficiency: The ratio reflects how effectively a company generates earnings from its operations to cover interest expenses, highlighting operational performance.

Interpretation of times covered

The interpretation of the times covered ratio depends on the industry and the specific financial context of the company. However, general guidelines for interpretation include:

• Ratio > 3: A ratio above 3 is typically seen as strong, indicating that the company has a healthy buffer to cover its interest payments and is unlikely to face financial distress.
• Ratio between 1.5 and 3: A ratio in this range suggests adequate coverage but indicates the company may face challenges if earnings decline or interest expenses increase.
• Ratio < 1.5: A ratio below 1.5 is a red flag, suggesting that the company may struggle to meet its interest obligations and could be at risk of default, especially if earnings decline.

Factors influencing times covered

Several factors can influence a company’s times covered ratio:

• Earnings Volatility: Companies with stable and predictable earnings are more likely to maintain a high times covered ratio compared to those with volatile earnings.
• Debt Levels: Higher levels of debt increase interest expenses, potentially lowering the times covered ratio.
• Interest Rates: Changes in interest rates affect the cost of debt. Rising interest rates can increase interest expenses, reducing the times covered ratio.
• Operational Efficiency: Efficient operations that generate higher EBIT can improve the times covered ratio by increasing the numerator in the calculation.

Industry benchmarks

The acceptable times covered ratio varies by industry due to differing capital structures and operational risks. For example:

• Utilities and Infrastructure: These industries typically have stable cash flows and can sustain lower interest coverage ratios.
• Technology and Biotech: These sectors often experience higher earnings volatility, so higher interest coverage ratios are preferred to mitigate risk.
• Consumer Goods and Retail: Companies in these industries typically maintain moderate interest coverage ratios, reflecting a balance between earnings stability and debt levels.

The times covered ratio is a vital tool for assessing a company’s financial health and its ability to meet interest obligations. By providing insight into earnings relative to interest expenses, the ratio helps stakeholders evaluate the risk and stability of the company, guiding investment and lending decisions.