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Finance: What is the Times Covered Interest Ratio? 23 Views


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What is the Times Interest Coverage Ratio? The interest coverage ratio divides EBIT by interest expenses. It looks at a company’s ability to pay off its interest on debt given earnings. If the ratio is low, these numbers are too close together, which shows that the company struggles to cover interest. The “times” aspect comes in because the ratio shows how many times a company could pay their debts using what they’ve made.

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Transcript

00:00

finance a la shmoop- what is the times covered interest ratio?

00:07

okay people. we'll just restate the question if it's simpler. from your [girl frowns in classroom]

00:11

operating profits this part of your income statement right here- how many

00:16

times is your interest expense covered? still not simple enough? okay how about

00:21

this? how big a multiple is your operating

00:24

profit of your interest cost? there we set it boom. okay so you run furry nation [definitions listed]

00:31

America's finest purveyor of animal bodysuits. the company has two billion

00:36

dollars in debt on which you pay six percent interest or 120 million dollars

00:39

a year. you really wanted that platinum encrusted fidgets spinner and well you

00:43

just couldn't wait. furry nation has revenues of three billion dollars and [hand spins fidget spinner]

00:47

conveniently has operating profits of 360 million. so how many times larger is

00:51

your operating profit than your yearly interest? well check out the hundred

00:56

twenty million dollars error of interest from before, that number gets divided

01:00

into the operating profit number. and the answer? three. well why does this ratio [equations]

01:04

matter? well the three times interest covered number is a solid indication of

01:09

how easily you can pay the interest if not the principle of the debt you have

01:14

borrowed. think about a normal boom and bust business cycle. in a bad year your [bridge blows up]

01:19

company might shrink to have only two billion of revenues and 180 million

01:23

dollars of operating profits. in which case in that dismal year it would have

01:27

only one point five times interest coverage. in a great year with say 900

01:31

million of operating profit while the coverage ratio would be 6x or 600 [equations]

01:36

percent or six times. now put your butt in the seat of the lender. if you're the

01:41

one who loaned the two billion dollars at 6% while you're getting pretty

01:45

nervous about being able to collect your money back when operating profits are

01:49

down to just one point five times. but it's six times interest well you sleep [woman snores in bed]

01:54

like a baby happy to keep collecting your interest payment though. so why do

01:58

we use operating profits this line here instead of net income or after-tax

02:03

profits this line here when we calculate the times interest ratio? well because

02:08

interest costs are tax-deductible? they're a cost just like [definitions]

02:13

plastic or office building rent or mandatory company yoga retreats. the cost

02:18

of renting money is treated for tax purposes really no different from the

02:22

cost of renting a building. so we don't worry about taxes when we're focused on

02:27

just repaying our debts. just don't try to use that excuse when tax time comes [woman smiles behind desk]

02:32

around though. Uncle Sam well he don't play.

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