Interest Cover Formula

Interest Cover Formula

Interest Cover can be calculated by the following Simple Formula

Interest Cover Formula =  Profit before Interest & Tax.                                               Interest Payable

 Interest Cover Formula Example

Company’s Profit after Interest = 130,000

Interest Payable = 40,000

Calculate interest cover ratio

Solution

Profit before interest = Profit after Interest + Interest

= 130,000 + 40,000

= 170,000

Interest Cover =   Profit before Interest    .   

                              Interest Payable

= 170,000/40,000

= 4.25 (Times)

This example shows that sufficient profit is available to pay interest i.e. 4.25 times than profit.

 Significance of Interest Cover Ratio

Interest cover ratio shows the financial position or capacity of company to pay interest. Interest is an obligatory payment and therefore this ratio provides important information to management for meeting its obligation.

Interest cover ratio provides margin of safety available to the company before it fails or defaults to pay interest on the debt. Interest cover ratio is also very important ratio for the current bond holder or debt financiers and future debt financier. They want to know about company ability or capacity to pay interest on debt Financing.

High Interest Cover Ratio

High interest cover ratio is recommended for companies, however a very high interest ratio indicates that company is not managing its finance properly, because debt is deemed to be cheaper than equity. Thus a very high interest cover ratio indicates that cheap source of financing is not being utilized by the company.

 Low Interest Cover Ratio

Management would love to maintain reasonable or balanced interest cover ratio, because a very low interest cover would shake the confidence of the debt instrument holder. Management would find it difficult to arrange new debt financing in case of low interest cover ratio.

 Ideal Interest Cover Ratio

 Interest cover ratio above 2 is regarded as safe point for the company. This shows that profit are twice that interest liability.

Limitations of Interest Cover Ratio

Interest cover ratio does not based on the cash flow information, which is more effective way or tool to measure the financial position of the company to pay interest. Thus interest cover ratio does not truly reflect the company’s capacity to pay debt.