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Interest cover is a ratio that can be used as a financial indicator. It communicates a company's ability to cover the costs of interest on its debts during a given period. This ratio is often used by investors trying to make decisions about purchasing or selling stock, and it is expressed as a number. The lower the number, the more risk that is associated with a company. The ratio 1.5 is recommended as a good minimum standard.
Interest is a recurring expense for many businesses. It is a charge that is assessed for borrowing money, and interest cover is an indication of a company's ability to cover those costs. This ratio is one of the factors that some investors consider when determining whether to purchase or sell a company's stock. Investors are often hesitant to put money into companies that appear to have trouble meeting their financial obligations.
Interest cover is commonly calculated by determining a company's earnings for a specific period and dividing the amount of its interest obligations for the same period. This most common method of figuring interest cover is often referred to as EBIT, which stands for earnings before interest and taxes. EBIT is the same as net earnings, and it serves as the numerator in the equation. The amount of interest serves as the denominator, and the result is the ratio that informs an investor of the company's ability to make interest payments.
The number produced from this equation communicates how many times a company can pay its interest obligations from available earnings. Interest cover is often expressed as a single-digit number. For example, a two would suggest that a company could make interest payments twice from its current revenues. A negative number indicates that a company cannot cover these obligations and is likely experiencing financial difficulty.
Low interest cover for a particular period may not be a reliable indication of a company's financial ability or the risk an investor faces. As earnings fluctuate, interest cover can also fluctuate, which prompts many individuals to assess a company's ability to pay interest over a span of time. An investor may look back months or years, depending on his strategy. It is important for new investors to understand that this ratio is rarely used as the sole factor upon which a stock decision is based. Financial professionals also strongly advise against owning a stock that has an interest cover lower than 1.5.
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