Interest Coverage Ratio

by Obaidullah Jan, ACA, CFA

Interest coverage ratio is a measure of a company’s ability to pay interest. It equals operating cash flows before interest and taxes divided by total interest payments. A higher ratio is better because it indicates availability of enough operating cash flows to meet the interest payment obligations.

Interest coverage ratio is a sister ratio of the times interest earned ratio which equals earnings before interest and taxes divided by interest expense. Cash flows are generally considered a better indicator of a company’s financial position and performance because they are less prone to distortions due to accounting policies and estimates. Finding out the number of time operating cash flows before interest and taxes are available to pay interest expense is useful in analysis of a company’s long-term financial strength.

Formula

Interest coverage ratio is a cash flow ratio. Both its numerator and denominator are obtained from statement of cash flows.

Interest coverage ratio can be calculated based on figures available in the cash flows from operating activities section of the statement of cash flows using the following formula:

$$ Interest\ Coverage\ Ratio=\frac{CFO+Interest+Tax}{Interest} $$

Where CFO is the net cash flows from operating activities, interest is the actual interest payment and tax represent the actual tax payment. We have added back interest because it is subtracted from operating cash inflows to arrive at the net CFO. We need to be careful here because some accounting standards allow companies to subtract interest payment as part of cash flows from financing activities. If that’s the case, we don’t need to add back interest. Tax is also added back because tax is charged after deduction of interest expense.

Example

Following is an extract from Volkswagen financial statements for the financial year 2015 and 2016.

Euro in millions 2016 2015
Cash flows from operating activities 9,430 13,679
Taxes paid 3,315 3,238
Interest paid (also interest expense) 3,247 2,393
Earnings before interest and tax 4,045 (3,694)

Calculate the company’s interest coverage ratio and contrast it with times interest earned ratio.

Following is the calculation of interest coverage ratios for 2015 and 2016:

$$ Interest\ Coverage\ Ratio\ (2015)=\frac{13,679+2,393+3,238}{2,393}=8.07 $$

$$ Interest\ Coverage\ Ratio\ (2016)=\frac{9,430+3,247+3,315}{3,247}=4.93 $$

The interest coverage ratios show that the company’s interest-paying ability is good because its operating cash flows are enough to cover at 8 times the interest payment in 2015 and almost 5 times the interest payment in 2016.

Times interest earned ratio is not meaningful in 2015 because the company has negative earnings before interest and taxes. In 2016, the company’s times interest earned ratio equals 0.80 which paints a bleak picture.

If we dig deeper, we find negative EBIT in 2015 was due to losses recognized on foreign-exchange derivative contracts.