The interest coverage ratio is a debt and profitability ratio used to determine how easily an entity can pay interest on its outstanding debt. EBIT is used in calculating the interest coverage ratio.
Interest coverage ratio= Earnings before Interest and taxes (EBIT) ÷Total interest expenses
Whereas EBIT is the operating profit of a company and Total Interest expenses are the interest payable on any borrowings such as bonds, loans, lines of credit, etc.
EBITDA or EBIAT are also used to calculate the interest coverage ratio instead of EBIT.
EBITDA is earnings before interest, taxes, depreciation, and amortization (EBITDA)
Interest coverage ratio= Earnings before interest, taxes, depreciation, and amortization (EBITDA) ÷Total interest expenses
Some people also calculate the interest coverage ratio by using the formula EBIAT/the total interest expense EBIAT, short for ‘Earnings Before Interest After Taxes.
The following formula is used to calculate it: Earnings Before Interest and After Taxes (EBIAT)= Revenue – Operating Expenses + Non-operating expenses.
This has the effect of deducting tax expenses from the numerator in an attempt to render a more accurate picture of a company’s ability to pay its interest expenses. Because taxes are an important financial element to consider, for a clearer picture of a company’s ability to cover its interest expenses, EBIAT can be used to calculate interest coverage ratios instead of EBIT.
It is a quite common accounting metric to analyse the risk associated with lending funds.
It is also used by investors to determine whether the firm they are investing in is profitable.
Interest coverage ratios cannot be uniformly applied to all types of business. Interest coverage is highly variable when measuring companies in different industries and even when measuring companies within the same industry. For established companies in certain industries, such as a utility companies, an interest coverage ratio of 2 (two) is often an acceptable standard.