Interest Coverage Ratio : Is shareholders wealth at risk?

As I am From Maharashtra, i am aware about the uneasiness of Marathi people with Debt. In my life i saw what happened in 2008. The way interest rates went up and that affect Indian corporate and the way some big and large companies went from sky-scrapper to SCRAP like JP Associate, Reliance capital, HDIL, DLF, even some banks like ICICI bank, RCOM, Essar steel and whole empire of Vijay mallya which in fact built up by his father from scratch etc etc. My hate for debt increased.

But when I came to Business Schools I came to know some facts which were making debt as hero. They tech me that debt is something magic. A thing which will increase your return. But what they don’t teach is this ratio VERY highlightedly  AS RED FLAG.

So I am not going to repeat it and going to give it importance here.

Borrowing money is one of the most effective things a company can do to build its business. But as they say THERE IS NO FREE LUNCH. There is cost for everything. For debt, its interest. Payable month after month, year after year. These interest payments directly affect the company’s profitability. For this reason, a company’s ability to meet its interest obligations, an aspect of its solvency, is arguably one of the most important factors in the return to shareholders.

Interest coverage is a financial ratio that provides a quick picture of a company’s ability to pay the interest charges on its debt. The “coverage” aspect of the ratio indicates how many times the interest could be paid from available earnings, thereby providing a sense of the safety margin a company has for paying its interest for any period. A company that sustains earnings well above its interest requirements is in an excellent position to weather possible financial storms. By contrast, a company that barely manages to cover its interest costs may easily fall into bankruptcy if its earnings suffer for even a single month.

Many peoples will give you different words for same formula

EBIT / Interest.

In short, Net Earning Before extra Ordinary Items  – Equity Income + minority Interest In subsidiary companies + all income taxes + All interest payments. Devided by total interest charges. As being student of Finance I know that Finance lease is also treated as debt and so you can add payment for them into it.

Now As with every industry capital structure is changing, The Rule of thumb was different. Less than one is ‘Beyond doubt bad’ But for sufficient good level, it is acceptable that the ratio is above 1.5 because there maybe other liabilities also like Preference Shares. personally I believe, As STONE AGE investor, Receiving dividend and watching it increase bit by bit is important so that is also cost.

Utility companies don’t have such large debt. Even if they have, their cash flow is sufficient large to take care itself. So 2 is good. For IT companies also the same, maybe little lower is also good. For Steel companies, Automobile and other Cyclicals 3 is good level of the ratio.

On some cases when the company is borrowing for capital assets which are important for company then This ratio is just useles.

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About Ashutosh Tilak

Tracking Indian Capital Market since 2010. Finance Student, On this blog I am writing about finance and Investing. You can contact me analystashu@gmail.com or @androidashu & @InsideFinanc on twitter