Buying stocks is arguably one of the best investments you could make in Canada today.
When looking to perform a fundamental analysis of a company, one of the first ratios investors often look at is the company's interest coverage ratio. For those of you just getting started with how to buy stocks, a company's interest coverage ratio is used by both analysts and investors. It can give vital insight into a company's financial health.
What is the interest coverage ratio?
In simple terms, the interest coverage ratio represents a company's ability to make interest payments on its outstanding debt.
If a company's interest obligations are higher than its earnings, it may be a red flag that it could be forced to restructure its debt, issue shares for capital, or, worst case, bankruptcy.
How to calculate the interest coverage ratio (times interest earned ratio)
To calculate the interest coverage ratio, also known as the "times interest earned" ratio, an investor has to take the earnings before interest and taxes (EBIT) and divide it by the company's annual interest expense.
If a company has $1 in EBIT and annual interest expenses of $0.1, it has an interest coverage ratio of 10.
Interest coverage ratio formula:
EBIT/Annual Interest Expense = Interest Coverage Ratio
In the above example, this would result in:
$1/$0.10 = 10
What is a good interest coverage ratio?
Generally, a higher interest coverage ratio is better. If you think about the formula above, this makes sense. The more earnings a company has relative to the interest accumulated on its debt, the better positioned it will be to not only pay that interest but also pay down the principle on the debt with cash flows if it feels the need to.
However, we must also look at interest coverage ratios relative to the industry. For example, comparing a utility company to a technology company would be unfair. Both operating environments differ, and the utility company will, in most cases, have much higher borrowings because of how expensive infrastructure development is in the sector.
It is essential to compare apples to apples. A good interest coverage ratio in the utility sector may be 2 or greater, while many companies in the retail sector have interest coverage ratios that exceed 6.
Using EBITDA for the interest coverage ratio
EBITDA, or "earnings before interest, taxes, depreciation, and amortization," is one of the most popular metrics in the financial sector. It calculates the company's available earnings before interest and tax payments are made and removes the impact of non-cash items like depreciation or amortization.
Although depreciation and amortization are most certainly "real" costs, they don't cost the company any physical cash. A company may buy a piece of machinery upfront and depreciate it over 5-10 years. You'll see this impact on net income half a decade after its purchase, but it will not impact the amount of cash the company has at that time.
It would certainly make sense for some sectors to factor depreciation and amortization into the interest coverage ratio. Generally speaking, if a company has a large amount of depreciation and amortization, excluding it would result in a higher interest coverage ratio.
A high-interest coverage ratio isn't always a good thing
Although a low interest coverage ratio is almost always a warning for shareholders, this financial ratio being too high can also be a warning sign.
Debt is often seen as a bad thing. However, companies with strong management and stability can often use debt to their advantage to fuel future earnings growth. A high interest coverage ratio could represent a company's inability to use debt and assets efficiently.
If the company's total interest expense on its debt is low and the potential to invest its current earnings into projects or acquisitions that have a good chance of driving long-term earnings growth over and above the costs of debt, an investor must consider whether or not the company is using its cash flow wisely.
Using EBIAT in the interest coverage ratio
Instead of using EBIT, which is earnings before interest and taxes, investors can calculate the interest coverage ratio by using EBIAT, which is earnings before interest but after taxes.
One thing that is ignored by a lot of investors when doing fundamental analysis is taxes. They have a real impact on company operations. In looking for the most conservative measure of a company's ability to pay its lenders and creditors, looking at its earnings post-tax will get you there.
The pros of the interest coverage ratio
- Much like the current ratio and quick ratio, it is a financial ratio that gives an investor the ability to gauge the health of a company's balance sheet quickly
- When looking at the interest coverage ratio over an extended length of time, it can give an investor some insight into the direction a company's financial health is heading
- When using this ratio to compare companies in the same industry, it can give an instant snapshot of the strongest/weakest companies in terms of financial health, along with the trend of their coverage ratios over the long term
The cons of the interest coverage ratio
- All companies have different debt structures. All else staying the same, a company with a shorter debt structure will have more volatility in its interest coverage ratio
- Sticking to the above, a volatile interest rate environment will result in the restructuring or rolling over of debt, causing more significant swings in the interest coverage ratio
- With cyclical companies, earnings can be pretty volatile over a given period. For example, during fiscal years in a recession, a high-end retailer may see its interest coverage ratio dip significantly, while economic booms see it rise.
Overall, the interest coverage ratio is a strong metric but must be used in combination with strong research
Much like we wouldn't use earnings calculations like the price to earnings or price to free cash flow in isolation to invest, the interest coverage ratio is best used in combination with thorough financial research.
Yes, it is a strong metric for detecting financial hardships among companies and potentially even the risk of bankruptcy. Still, there can be short-term swings in earnings or potentially even particular company structures that warrant abnormally high/low coverage ratios. A prime example of this would be a regulated utility, which has consistent enough earnings that the market often accepts lower coverage ratios.
We can also see that there are plenty of variations in calculating this ratio. So, ensure you aren't using multiple ratios (EBITDA, EBIT, EBIAT) in your research.