This ratio is calculated as earnings before interest and taxes (EBIT) for the most recent financial year divided by the interest expense for the same period. Earnings before interest and taxes is calculated as sales minus operating expense – which includes cost of goods sold, selling and general expenses etc. Interest expense is paid out on the outstanding debt amount of the company, higher the debt higher the interest pay out.
Suppose EBIT of the company is Rs.120 and interest expense is Rs.50, interest coverage ratio is 2.4, indicating that the company has Rs.2.4 for every Re.1 of interest payment.
This ratio helps understand whether the company can pay off its interest obligations in a timely manner. If the ratio is less than 1, it indicates that the company’s operating profit is not sufficient to make interest payments and that the financial health of the company is in dire straits. A number equal to 1 means all operating profits will be expended towards make interest payments and net profit will be zero. Higher the coverage ratio above 1 better the financial health of the company.