Interest Coverage Ratio

Interest coverage ratio

The ability of a firm to meet its debt service costs out of current earnings is a rough indicator of its long-term solvency. Long-term loans which are usually in the form of debentures carry interest charges which must be paid regularly. The inability to meet such interest charges places the firm's solvency into jeopardy. The interest coverage ratio is calculated as follows:

Income before interest and tax Interest coverage ratio = Periodic interest charges

Generally speaking, a firm which can cover its debt service costs several times over by its operating income even in a poor year would be regarded as a satisfactory risk by long-term creditors.

The analysis of financial performance

There are two aspects of a company's financial performance of interest to investors. First, its financial performance may be assessed by reference to its ability to generate income. Ratios of financial efficiency in this respect focus on the relationship between income and sales and income and assets employed. Second, its financial performance may be assessed in terms of the value of its shares to investors. In this sense, ratios of financial performance focus on earnings per share, dividend yield and price-earnings ratios.

The analysis of efficiency as earning power

The overall measure of earnings performance for purposes of comparison is the ratio of return on capital employed. This ratio is made up of several components, two of the most important of which are the asset-turnover ratio and the return-on-sales ratio.

The ratio of return on capital employed

There are several ways of expressing this ratio, and care must be taken in making inter-firm comparisons that the basis used is the same. The ratio of return on capital employed may be expressed as follows:

(1) Net income/Shareholders' equity (i.e., Share capital + Reserves)

(2) Net income + Interest/Equity capital + Long-term liabilities

(3) Net income/Gross tangible assets

The main problem with this ratio lies in the diversity of generally accepted principles applying to the measurement of net income and values. In selecting the appropriate denominator, for example, there is also a choice as indicated above. When considering the firm's efficiency in generating income, it is more appropriate to use total assets, that is net fixed assets plus current assets, as the denominator. Investors, on the other hand, would be more interested in relating net income to the value of the shareholders' equity. In this section, we shall assume that we are seeking a measure of the firm's internal efficiency in the generation of income, and use the ratio of net income to total assets.

These ratios may be further subdivided, for example, by a closer analysis of the components of current assets, that is inventories and debtors, and the elements of direct and overhead expenses.

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Read on: Other Factors Affecting Short-term Solvency

Other factors affecting short-term solvency

In addition to the ratios mentioned above, other factors which should be taken into account when evaluating short-term solvency include:

(i) The size of operating costs. Neither the income statement nor the balance sheet reveal the cash required to meet current operating costs such as

228 Accounting Theory and Practice

payroll, rent and other expenses, except where these are shown as outstanding on the balance sheet. Where a firm has very little current debt in its favour on the balance sheet, and it is faced, for... see: Other Factors Affecting Short-term Solvency