Interest coverage ratio is the part of analysis of long term solvency. This ratio is the relationship between net profit before tax and interest and total fixed interest charges. This ratio's second name is net profit to debt service ratio or debt service ratio because with this ratio, we check our net profit's capacity for paying interest on our long term debts. Creditors are interested that company may give interest on their loan or not. If our net profit is very high than our interest payment, at that time, we can say that we have capacity to pay our all interest payment liabilities.
Following is the formula of interest coverage ratio:
= Net profit before interest and tax / total interest charges
Example
For example, we have net profit after tax is Rs. 10000 and our tax is 50% on net profit and our payment of interest is Rs. 10000.
In this question, we have given net profit after tax, it means we have to calculate net profit before interest and tax first.
EBIT = Net profit after tax + Tax + interest = 10000 + 10000 + 10000 = 30000
Interest = 10000
ICR = 30000 / 10000 = 3 times
It means, we have 3 times capacity to pay interest on debt. But this is not sufficient because it should be high. Suppose, if we increase our net profit upto Rs. 50000, at that time our EBIT will be Rs. 110,000. So, our ICR will be = 110000 / 10000 = 11 times
It means, we can pay Rs. 10,000 even times without taking any short term loan, if we have Rs. 50000 net profit after tax. Now, we understood that all creditors are money minded. So, we have to secure ourselves by increasing our profit, otherwise, our creditors will take benefit of our this weak point.
How can they take benefit, if our profit is very low?
Simple answer : In future, they will give us loan at high rate of interest because they feel more risk of their money. With this, our fixed cost will increase. This fixed cost will decrease total profitability of shareholder. Less EPS will decrease the value of share in the market. Next, you can understand the future of that company.
= Net profit before interest and tax / total interest charges
Example
For example, we have net profit after tax is Rs. 10000 and our tax is 50% on net profit and our payment of interest is Rs. 10000.
In this question, we have given net profit after tax, it means we have to calculate net profit before interest and tax first.
EBIT = Net profit after tax + Tax + interest = 10000 + 10000 + 10000 = 30000
Interest = 10000
ICR = 30000 / 10000 = 3 times
It means, we have 3 times capacity to pay interest on debt. But this is not sufficient because it should be high. Suppose, if we increase our net profit upto Rs. 50000, at that time our EBIT will be Rs. 110,000. So, our ICR will be = 110000 / 10000 = 11 times
It means, we can pay Rs. 10,000 even times without taking any short term loan, if we have Rs. 50000 net profit after tax. Now, we understood that all creditors are money minded. So, we have to secure ourselves by increasing our profit, otherwise, our creditors will take benefit of our this weak point.
How can they take benefit, if our profit is very low?
Simple answer : In future, they will give us loan at high rate of interest because they feel more risk of their money. With this, our fixed cost will increase. This fixed cost will decrease total profitability of shareholder. Less EPS will decrease the value of share in the market. Next, you can understand the future of that company.
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