As a good financial management principle, it is always advisable to have an optimum mix of debt and equity to maximize your return on the capital invested into the business. Equity is the amount of capital invested by the owners of the business while debt consists of the business loans, mortgage loans availed from banks and financial institutions.
When one takes loans from banks, it has to service the debt by the regular principal and interest payments. So, indeed it makes sense to know how better placed you are in terms of servicing your debt obligations, especially the interest part.
You can get a fair idea of your financial health and ability to service the interest payments by calculating interest coverage ratio. It is a measure of the company’s comfort to make the interest payments in a timely manner. It is calculated as earnings before interest and taxes divided by total interest expense. In simple terms,
Interest Coverage Ratio = (Profit before Tax + Finance Costs)/ Finance Costs
For example, your business has a profit before tax of Rs. 1000 and your finance costs are Rs. 500. Your earnings before interest and taxes will accordingly be Rs. 1500 (Rs. 1000 plus Rs. 500). Your interest coverage ratio in such a case will be 3 (Rs. 1,500 divided by Rs. 500). This implies that you have three times higher profits than your present interest obligations.
It basically lets you have a fair idea of how far a company’s earnings can decline before it will begin defaulting on its debt payments. As a thumb rule, the lower the interest coverage ratio, the riskier perception banks will have about your business. Similarly, the opposite conclusion is equally true. The higher the interest coverage ratio, the lesser the chances are of default.
The ratio generally deteriorates in a case when the debt burden is rising for the company, with not much growth in the earnings. The increased debt burden results in higher interest cost and thus reflects through lower interest coverage ratio. If you notice a trend of declining interest coverage ratio in your financials, you must indeed be on a lookout for reasons. This might be due to bad financial management or rising interest rates in the economy. In such a scenario, you must make efforts to optimise your business loans.
Read about how debt consolidation can help you improve your financial strength .
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