The interest coverage ratio.
What is it, how do you calculate it, what are its uses and limitations?
The interest coverage ratio is a financial ratio that attempts to measure how easily
a company can pay its interest expenses on outstanding debt.
The key word in this sentence is “attempt”, as it is not always successful in achieving its goal.
The formula for the interest coverage ratio is Operating Income (or a variation thereof)
divided by interest expense.
Both of these can be found in the income statement.
The amount of interest expense is a function of the amount of outstanding debt that a company
has, and the interest rate that the company pays on that debt.
With Operating Income in the numerator, and interest expense in the denominator, another
name for the interest coverage ratio is “times interest earned”.
As in: how many times the interest do you earn in Operating Income.
If the interest coverage ratio is 10, then that means that for every $ of interest expense,
there is $10 of Operating Income to cover it.
If the interest coverage ratio is 2, then that means that for every $ of interest expense,
there is only $2 of Operating Income to cover it, and you are much more fragile to either
a decrease in Operating Income or an increase in interest expense.
We will see how this works in upcoming examples.
In general, the higher the interest coverage ratio, the more likely a company is to be
able to make its interest payments, which should comfort lenders, creditors and shareholders
about the long term viability of the company.
Let’s see if we can calculate the interest coverage ratios for each of the years of a
three year period for the following companies:
Apple, Boeing, Home Depot,
McDonald’s, Tesla and Verizon.
For how many of these companies can you successfully calculate
the interest coverage ratio for 2017, 2018 and 2019?
The answer to that question is: only two out of the six!
Let me show you, and explain you why you can or can’t!
Home Depot.
Let’s take the consolidated statement of earnings, locate the lines for Operating Income
and for interest expense, and then divide.
The interest coverage ratio was 13 for fiscal year 2019,
15 for fiscal year 2018, and 14 for fiscal year 2017.
For every $ of interest expense, in the past couple of years, there was between $13 and
$15 of Operating Income to (easily) cover it.
As there was sufficient Operating Income to cover interest expense, there are enough earnings
left to cover taxes and Net Income.
McDonald’s.
Take the consolidated statement of income, locate the lines for Operating Income and
for interest expense, and then divide.
The interest coverage ratio was 8 for 2019, down from 9 for 2018, and 10 for 2017.
For every $ of interest expense, there was between $8 and $10 of Operating Income to
(easily) cover it.
Those were two companies for which we can easily calculate the interest coverage ratio.
How about the other ones?
If we review Apple’s income statement, we find plenty of Operating Income: $60 to $70
billion per year.
But we don’t see a line item for interest expense.
What’s going on here?
Apple does have interest expense,
but it is reported as part of the “Other Income and Expense” line.
If you analyze that line, interest and dividend income in line one,
is far bigger than interest expense in line two.
As a result, we cannot calculate the interest coverage ratio.
Apple has such a strong financial position, that interest coverage ratio is not a meaningful
metric (and by the way, neither is a liquidity metric like the current ratio).
How about Boeing?
We have an Operating Income number for 2018 and 2017, but an Operating Loss for 2019.
Each of the three years has interest expense.
So we can easily calculate the interest coverage ratio of 29 for 2017 and 25 for 2018, but
due to the Operating Loss (in other words negative Operating Income) in 2019 the interest
coverage ratio for 2019 cannot be calculated.
As Boeing had a very difficult year in 2019, this is exactly the year for which we want
to test its financial health, but the interest coverage ratio cannot provide us any information.
Next up is Tesla.
Tesla is at a far earlier stage of business maturity than any of the businesses we analyzed so far.
The Operating Loss has been shrinking from 2017 to 2019, but has not yet turned positive.
Hence no interest coverage ratio can be calculated for any of these years.
Verizon.
Here we have a substantial amount of Operating Income for each of the years, and a fairly
stable amount of interest expense for each of the years.
We can easily calculate the interest coverage ratio for each of the three years: 6, 5, and 6.
The difficulty lies in the interpretation.
Does the interest coverage ratio (defined as Operating Income divided by interest expense)
really tell the full story of how easily Verizon can pay its interest expenses on outstanding debt?
Verizon is a very capital intensive business, with around $17 billion per year in depreciation
and amortization, which is a non-cash expense
(it affects current year earnings, but not cash flow).
What does affect cash flow, is a CapEx spend of $10 to $13 billion per year (which affects
cash flow, but not current year earnings).
On top of that, Verizon recorded a $4.6 billion non-cash goodwill impairment in 2018, which
reduced Operating Income for that year, but did not have any cash flow impact.
Rather than calculating the interest coverage ratio based on income statement data, we might
be better off analyzing Verizon’s cash flow statement (operating, investing and financing
cash flows) to see how easily Verizon can pay its interest expenses on outstanding debt.
Interest coverage ratio.
Operating Income divided by interest expense, assuming that Operating Income is positive,
and assuming that the company you review actually has any interest expense.
For mature and profitable companies, with no unusual items in their financial statements,
and more debt than interest-earning assets on the balance sheet, this can be a meaningful
metric to measure how easily a company can pay its interest expenses on outstanding debt.
For companies outside that category, there are far more meaningful financial ratios we can use!