Legal Definitions - interest-coverage ratio

The interest-coverage ratio is a financial metric used to evaluate a company's ability to meet its interest payments on outstanding debt. It calculates how many times a company's earnings, before accounting for taxes, can cover its annual interest expenses on loans and bonds. A higher ratio indicates a stronger financial position and a greater capacity to pay its debt obligations, making it a key indicator for lenders and investors assessing risk.

• Example 1: A Growing Manufacturing Firm Seeking Expansion Capital

  Imagine "Global Gears Inc.," a manufacturing company that had $10 million in pretax earnings last year. Its total annual interest payments on existing bank loans and corporate bonds amounted to $2 million. To calculate its interest-coverage ratio, we divide its pretax earnings by its annual interest payments: $10,000,000 / $2,000,000 = 5.

  This ratio of 5 means Global Gears Inc.'s earnings are five times greater than its interest obligations. This strong ratio would be very favorable to a bank considering a new loan application from Global Gears Inc. for a factory expansion, as it demonstrates the company's robust ability to comfortably cover its current and potentially future interest expenses, indicating a low risk of default.

• Example 2: A Retail Chain Facing Economic Downturn

  Consider "Fashion Forward Stores," a retail chain experiencing a significant drop in sales due to a recession. In the current year, Fashion Forward Stores reported $1.5 million in pretax earnings, while its annual interest payments on its various store leases and corporate debt totaled $1 million. Its interest-coverage ratio would be: $1,500,000 / $1,000,000 = 1.5.

  A ratio of 1.5 indicates that Fashion Forward Stores' earnings are only 1.5 times its interest obligations. While still able to cover its payments, this ratio is significantly lower than its historical average of 4. This signals potential financial stress to investors and lenders, suggesting that the company has a much smaller margin for error if its earnings decline further. It highlights increased risk compared to its healthier past performance.

• Example 3: A Stable Public Utility Company

  Take "City Lights Power," a public utility company known for its stable and predictable revenue streams. Annually, City Lights Power consistently generates $20 million in pretax earnings. Its long-term debt, primarily from infrastructure bonds, requires $4 million in annual interest payments. The interest-coverage ratio for City Lights Power is: $20,000,000 / $4,000,000 = 5.

  This consistent ratio of 5 demonstrates the utility company's strong and reliable financial health. Even with substantial debt to fund essential infrastructure, its predictable earnings comfortably cover its interest expenses. This stability makes City Lights Power's bonds an attractive investment for those seeking steady returns with minimal risk, as the company's ability to pay its interest is well-assured.