Current Ratio – Formula, Meaning, Assumptions and Interpretations
February 12, 2025
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The interest coverage ratio is a number that has a lot of importance for the creditors of the firm. This number tells them how safe their investments are and how likely they are to get back principal and interest on time.
Interest Coverage Ratio = EBIT / Interest
The interest coverage ratio tells investors how many rupees they have made in profit, per rupee of interest that they owe to their shareholders. Thus if the interest coverage ratio is 3, then the firm has 3 rupees in profit for every 1 rupee in interest obligations. Thus profits will have to fall by more than 66% for the firm to register a loss.
The standard assumption of no accounting manipulation in either of the two numbers involved (EBIT and Interest expenses in this case) is made while calculating the interest coverage ratio.
On the other hand, companies with highly variable sales, like technology and apparel companies, need to have a high interest coverage ratio. These industries are prone to wild fluctuations is sales and investors want to ensure that their cash flow is not interrupted as a result. Hence they demand a higher interest coverage ratio before they give out their money.
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