Suddenly the demand for your company’s products is overwhelming its existing capacity to meet it. It’s either you rise to the occasion and meet increasing demand or you lose the patronage to a competitor and fizzle out. You don’t want to fizzle out, so you must approach investors for long-term funds.
Investors will want to assess the strategic way you have been financing your business. They will want to know, “will you earn enough profits to meet interest payments when due?”
Interest cover ratio is the financial analysis tool you can use to make a self assessment before you approach investors.
What is Interest Cover Ratio?
Interest cover ratio is a capital structure ratio that shows whether enough profits are being earned to meet interest payments.
Interest cover is a long-term ratio that focuses on strategic level of corporate decision making as opposed to operational level decision making.
Note that capital structure as used above, refers to how a company finances its activities, growth and expansion. It is a combination of a company’s equity (including ordinary share capital, retained profits) and debt (loans).
How is Interest Cover Ratio Calculated?
Interest cover is calculated by dividing Profit Before Interest and Tax (PBIT) by the interest charges.
How important is interest cover ratio?
The fact that a company is making profit is not a guarantee that there will be enough cash to pay interest charges when they fall due.
This is why investors will want to assess your company’s financial statements to reach conclusions about the operational and strategic activities and, the financial health of your company.
So interest cover ratio will help investors to assess the level of solvency of your company. It is believed that a company with high solvency will dedicate a portion of its operating profit to pay interest charges.
What is a good interest cover?
Analysts say a good interest cover should not be less than three times.
Let us look at an example. If profit before interest and tax is $800,000 and the total interest charges are $40,000, the interest cover is;
$800,000/$40,000 = 20 times.
The interest cover is 20 times and this means that the chances of getting investors supports are high.
This interest cover ratio indicates a stronger financial health (more solvent); there is sufficient operating profits to meet interest payments when due.
The lower the ratio the higher the chances of the company being exposed to volatile interest rates.
However, low interest cover doesn’t always mean low solvency and consequently, inability to pay interest charges when due. In industries with stable sales such as utilities, low interest coverage ratio is enough.
On the other hand, industries with unstable highly variable sales such as apparel need to have high interest coverage ratio.