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Saturday, July 18, 2009

Interest Coverage Ratio

From The Hoss's Mouth

Interest coverage ratio is the topic of today's Hoss Cents Free Financial Money Magazine. This ratio indicates a company's capacity to make its interest payments (on all outstanding debts) with its earnings before interest and taxes. Think of it this way, how often could you make the interest payments all your outstanding debts with your annual pre-tax income? This is of great importance to bond and preferred stock investors. It gives these investors an indication of the company's financial stability and how far earnings can fall before possible bond or preferred stock payment defaults.

The higher the ratio the less a company is burdened by debt expense. A company's ability to meet interest expenses becomes suspect when the interest coverage ratio is 1.5 or lower. An interest coverage ratio below 1 is a strong red flag, as the company does not have sufficient revenues to pay its interest expenses. Exception: Some companies may have no debt and therefore no interest payments, in which case their Interest coverage ratio would be 0, which of course is excellent.

Interest coverage ratio is calculated as follows:

EBIT (earnings before income and taxes) divided by Interest Expense.

Money Magazine Hoss will again, as in Calculating Gross Profit Margin Percentage and Calculating Operating Margin, use the Income Statements of Amazon, Google and GM for demonstrating how to calculate interest coverage ratio.

Interest Coverage Ratio for Amazon:

2006: $455,000/$78,000 = 5.8

2007: $737,000/$77,000 = 9.4

2008: $972,000/$71,000 = 13.7

In all three years Amazon's Interest Coverage Ratio is well above the warning level of 1.5. In addition the ratio has increased each year which is a positive signal.

Interest Coverage Ratio for GM:

2006: $11,998,000/$16,945,000 = .71

2007: $-3,351,000/$2,902,000 = -1.15

2008: $-27,043,000/$2,345,000 = -11.53

If you considered buying GM stock in 2006, the interest coverage ratio of .71 would have been a warning sign that things were not at all well with this company. The continued deterioration in 2007 and 2008 confirmed this warning sign: Definitely a poor investment.
In fact as we all now know, GM subsequently filed for Chapter 11 bankruptcy protection.

Interest Coverage Ratio for Google:

2006: $4,011,297/$257 = 15,608.16

2007: $5,675,183/$1,203 = 4,717.52

2008: $5,853,596/$0 = 0

Google once again is the star. Its ratios are off the chart, and in fact as can be seen in the year 2008, they had no interest expense.

Stay on Track,

Money Magazine Hoss

Next Hoss Cents Free Financial Money Magazine Post: Net Profit Margin
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Related Financial Statement Calculation Information Posts:

Financial Statements Explained

The Balance Sheet

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