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Interest Coverage Ratio (Formula, Examples) | Calculate Interest Coverage Ratio - YouTube
Channel: WallStreetMojo
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hello everyone welcome to the channel of
Wallstreetmojo today we are going to
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discuss a topic on interest coverage
ratio most of the companies have borings
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long term as well as short term and they
have to pay interest on the same so the
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investors need to keep a check on the
fact that where the company will be able
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to pay the interest on timely basis so
for this a financial ratio named as
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interest coverage ratio is very useful
see as you can see from the chart the
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Sun has interest coverage ratio of close
enough to 186.42
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in case of ford but the interest coverage ratio is close enough to 28.44
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so seems to be that the Sun has a good prestige in the
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market because of higher coverage as
compared to what Ford is able to so that
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is what we are going to evaluate over
here see interest coverage ratio
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basically helps to determine how easy a
company can pay interest on its
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outstanding debt so interest coverage
ratio can be classified as a debt ratio
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because that gives us the idea a general
idea about the financial structure and
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the overall financial risk faced by the
company see interest coverage ratio can
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also be classified as a solvency ratio
because that helps to understand whether
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the organization is solvent and whether
there are any near threats pertaining to
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bankruptcy now what is interest coverage
ratio by one single version see interest
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coverage ratio is a ratio which helps to
decode whether the company will be able
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to pay interest on timely manner there was
this guy called mr. Benjamin raha he was
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the author of a very famous book name
called the intelligent investor and call
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the interest coverage ratio as a part of
a margin of safety and he explained the
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term by comparing it to the engineering
of a bridge see when the construction of
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a bridge the weight it can carry is declared as say close enough to 10000
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pounds but while the actual maximum
weight limit which it is built for
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30,000 pounds so the that extra 20,000
pound it represents what it represents
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the margin of safety so to accommodate
the unexpected situation basically this
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margin of safety is nothing but to
accommodate the unexpected situation or
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unexpected cases now in the same way
interest coverage ratio represents the
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marginal safety with regards to
organizations interest payment to a
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certain extent this ratio also helps to
measure the financial stability of a
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company or the hardships it can face on
account of its boring see equity and
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debt are the very two sources of the
funds for any company an interest is the
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cost of a debt for the organization
analyzing whether a company is in a
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position to pay this cost is very
important therefore this is a very
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critical ratio for a shareholder and the
lender of the company now interest
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coverage ratio formula this is very
important let's learn what is interest
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coverage ratios formula interest
coverage ratio is calculated with a very
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simple formula let's dig into this we
will write interest coverage ratio okay
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and when what is equal to sign saying
interest coverage ratio is earning
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before interesting tax that is called a
EBIT for the period earning before
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interest and tax for the period divided
by you will say the total interest total
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interest payable in the given period so
this is going to be your formula for
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interest coverage ratio earning before
interest and tax is your operating
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profit of the company so operating
revenue minus all the operating cost
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will give you the operating profit so
operating profit for the period divided
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by the total interest the formula is
trying to say that well what is the
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level of interest is getting covered up
in the operating profit of the company
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let's dig into an example like let's understand this formula better with the
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help of all example okay so I'll cover
the next sheet
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let's see that what we can make some
conclusion from this particular example
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see there is a revenue revenues coming out
from two particular things project
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advisory and consultancy fee that gives
us the total revenue there are a couple of
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expenses the total operating expense is
close enough to
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111800 and in 2014 it's 106300 this
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is the operating income A that is A-B and less any other expenses that
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will give us earning before interest and
tax that is EBIT which is important to
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us less the interest that gives us the
profit before tax and you deduct tax you
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get back so let's now calculate the interest
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coverage ratio with the help of taking a
Ebit as a base so interest coverage ratio
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let's calculate this one for the year so
just just keep it interest coverage
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ratio we have 2015 and 2014 so we don't
need to under the enter the year
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before interest in taxes 19100 divided by the interest that
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is 9200 that is 9.79 is the coverage
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ratio and what was in 2014 so let's
check that in EBIT
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divided by the interest so it was 10.22 coverage and in 2015 it
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drops down to 9.79 so the condition has not improved the
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condition has deteriorated that means
the profits are reducing in terms of the
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previous year compared to the previous
year and the interest as also has taken
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a rise so this is how you calculate the
interest coverage ratio now you could
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also calculate this is interest coverage
ratio with the help of EBIT I'll just
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write over here EBIT now interest coverage ratio
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formula can also be used can also be
calculated with the help of EBITDA now
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what do you win by EBITDA very important element because in finance
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this word is really this particular thing is very important EBITDA that
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means earning before interest tax
depreciation and amortization so a
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slight variation of the above to add any non-cash expenses to EBIT
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any knows non-cash expenses to EBIT will
give us EBITDA and then calculate
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the interest coverage ratio so the formula
for the same is EBIT for the Period plus
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any non-cash expenses so I'll just copy
over here I'll say control V EBIT for
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the period you will just need to add any
non-cash expenses over here and that's
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it / everything remains the same so this
is the interest coverage ratio for EBIT
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for EBIT and the below one is for EBITDA
for EBITDA so that is it now see
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basically the what exactly include
includes this non-cash expense non-cash
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expense is like depreciation or
amortization for most of the companies
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so to understand this formula first let
us understand I mean what do we mean by
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non-cash expenses see as the name itself
suggests this are the expenses incurred
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in the books of accounts but there is no
actual cash outflow on account of this
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expenses a very good example of this is
depreciation see depreciation measures
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the variant thereof of the fixed asset
on yearly basis but does not lead to any
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cash outflow so the logic behind adding
this non-cash expenses is to arrive at a
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figure which will be available for
payment of interest in a true sense and
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not just as for the book profit so if we
add this expenses the interest coverage
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ratio will definitely increase so taking
the above example we have let's let's
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calculate the interest coverage ratio
with the help of EBITDA
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so will say EBIT will have to add back any depreciation divided by we will
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have to divide by interest will put this
completely in a bracket once we do that
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the interest coverage ratio you can see
it has automatically increase it was
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9.79 by increasing the depreciation it is quite logical
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that the amount will go up so in the
similar fashion you can do
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can just do ctrl R and C again over here
it has increased so if you want to copy
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any formula in a row wise you can you
can go for ctrl R and any column wise
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you can go for ctrl D so Financial
Analysts use either the first formula or
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the second formula depending upon first
means EBIT or second means EBITDA and
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the the the uses formula depending upon
what the fee is more appropriate to them
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and depending upon various other
criterias see interest coverage ratio
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I'll give you of colgate using EBITDA method see let is not calculate
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interest coverage ratio of colgate in this particular example now what we're
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going to do will be using EBITDA formula now Colgates interest coverage
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ratio is equal to EBITDA / interest expense okay will
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use the second formula now in in Colgate
the depreciation and amortization
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amortization expenses were not being
provided in the income statement and you
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can easily find those in the cash flow
operation section now also interest
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coverage ratio of Colgate very healthy
and it has maintain interest coverage
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ratio in excess of 100 X for the past
2 years old also in 22 2013 the net
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interest expense was negative the
interest expense and interest in Less
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the interest income hence the ratio was not calculated now
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let's make an interpretation of this
interest coverage ratio see interest
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coverage ratio is a solvency check for
the organization in simple words the
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ratio measures the number of times the
interest can be paid with the given
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earning of the company therefore higher
the ratio better it is so a higher the
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ratio means that the organization has
sufficient buffer even after paying
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interest now in the above example of
message high earners limited like as we
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learn as the interest coverage ratio of
a approximately 10 for 2040 and this
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means that it had enough buffer to pay
the interest for 9 times over in
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about the actual interest payable so putting
it in other words one can say that lower
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the ratio more the burden on the
organization to pay the cost of debt now
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when the ratio tips to below 1.5 it
means a red alert for the company it
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indicates that it may be barely be able
to cover the interest
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expense anything below 1.5 means the
organization might not be able to pay
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the interest on borings now there are
very high chance of default in this case
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and it may also create a very negative
impact on the goodwill of the company as
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all the lenders will be very cautious
about the invested capital and any
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prospective lenders will shy away from
this opportunity also in case the
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company is unable to pay interest it may
end up borrowing more and they fall to
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debt trap I mean this generally worsens
the situation lead to a loop where the
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company keeps on boring to more to cover
its interest expense now what happens if
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the interest coverage ratio actually
falls below 1 in this case it means that
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you know the company is not generating
enough revenue which is why the totaling
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these people is more than the earning
before interesting tax this is a strong
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indicator of a default below 1 so this
often leads to a risk of falling into
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bankruptcy I know in most of the cases
the main interest coverage ratio should
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be around 2.523 and this much is enough to not trigger a red flag however
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there can be many instances where a
company has to maintain a higher ratio
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such as a strong internal policy but the
management has been dated to maintain a
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higher ratio and there may also be
contractual requirement of various
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borrower was a company to maintain a
high ratio also different industry may
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have a different level of acceptability
of interest coverage ratio generally
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industries where the sales are stable
such as like basic utilities can do with
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a lower interest coverage ratio this is
because they have a comparatively steady
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EBIT and their interest can easily be covered in case of difficult times
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whereas industries which tend to have
fluctuating sales such as like
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technology should have a comparatively
higher interest coverage ratio here the
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EBIT will fluctuate here the EBIT will structure in accordance with the
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sales as the best way to manage the cash
flow is by keeping keep buffer cash by
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maintaining a higher ratio what is the
limitation of in the interest coverage
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ratio see like every other financial
ratio interest coverage ratio has its
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own set of limitation as well some of
the limitations are as for unlikely
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looking at the ratio for a given period
may not
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the true picture of the company's
position as there can be seasonal
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factors which can hide the stock the
ratio and for example in a given in the
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in the given period the company has
exceptional revenue on account of new
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product launch which is already banned
by the government going forward so
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looking at theme just coverage ratio
only in this period may give the
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impression that company is doing well
however if the ratio is compared to the
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next period it might show a totally different picture so an important
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shortcoming of this ratio is that the
ratio of this is not consider the effect
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of the tax expense to the organization
tax expenses deducted after earning
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before interest in tax and that's affects
the cash flow of the organization and it
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can be deducted from the numerator of
the ratio to arrive it better see
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consistency in accounting policies and
principle followed while preparing
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financial statement can also be very
critical factor in analyzing the past
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trends and comparing industry peers
while calculating the interest coverage
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ratio best way of using interest
interest coverage ratio is to use
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financial ratio is to use an umbrella of
the ratios at given point of time many
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other financial ratio ratio such as cash
ratio quick ratio current ratio debt
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equity ratio and p/e ratio etc should be
used along with the interest coverage
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ratio for effective analysis of the
financial statement this helps to
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maximize the advantage of this ratio and
at the same time minimize their
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limitation thank you
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