What is a cover of interest?

What Is Interest Cover Ratio?

• Answer:

  Businesses usually finance their operations and purchases with a combination of equity capital, long-term loans and short-term debts to suppliers. However, a business has limitations on the amount of debt it can comfortably manage. The interest cover ratio is a metric that measures a company's ability to handle long-term debt. Definition The interest coverage ratio is a measure of a company's free cash flow compared to its annual interest charges for long-term debt. Free cash flow is defined as earnings before deductions for interest, taxes, depreciation and amortization -- EBITDA. This figure is divided by the amount of interest to get the coverage ratio. Application Managers, lenders and analysts use the interest coverage ratio to gauge a company's ability to meet its interest payments. A higher ratio is more desirable, because it indicates the company has excess cash flow available to handle unexpected downturns in sales. Generally, lenders prefer to see an interest coverage ratio of at least 3:1. For a ratio less than that, the lender may request additional information from the borrower to make a more detailed analysis. Lenders usually do not make loans when the ratio falls below 1.5:1, according to an Inc. article by Walter G. Kortscha titled "The Right Amount of Leverage." Ratings Lenders have a rating system they use to grade the financial strength of a company in terms of the interest coverage ratio. For low market capitalization firms, an interest coverage ratio greater than 12.5:1 gets a AAA rating, while a ratio less than 3:1 only gets a B+ rating, according to a table provided on the New York University website. The interest cost to the borrower goes up with higher ratios and the resulting lower ratings. Industry Averages Several publications and numerous trade associations provide average financial ratios, including the interest coverage ratio, for a large number of industries. Bankers may use the "RMA Annual Statement Studies," which is published by Robert Morris Associates. Dun & Bradstreet issues its "Industry Norms and Key Business Ratios." Although these publications are paid subscriptions, most public libraries maintain recent copies. Yahoo Finance has financial ratios for various industries, and it is available for free online.