Interest Cover (Fixed-Charge-Coverage Ratio)

Interest Cover (Fixed-Charge-Coverage Ratio)§

Definition: Interest cover, also referred to as the fixed-charge-coverage ratio, measures the number of times a company can cover its interest obligations from its earnings before interest and tax (EBIT). This ratio is crucial in evaluating a company’s financial stability and its vulnerability to interest rate changes or profit fluctuations.

For example, let’s consider a company with interest charges of £12 million and EBIT of £36 million. The interest cover ratio would be: $$\text{Interest Cover} = \frac{\text{EBIT}}{\text{Interest Charges}} = \frac{£36 \text{ million}}{£12 \text{ million}} = 3$$

Examples§

1. Company A:

   • EBIT: $50 million
   • Interest Charges: $10 million
   • Interest Cover: $$\frac{50 \text{ million}}{10 \text{ million}} = 5$$

2. Company B:

   • EBIT: £24 million
   • Interest Charges: £8 million
   • Interest Cover: $$\frac{24 \text{ million}}{8 \text{ million}} = 3$$

3. Company C:

   • EBIT: €18 million
   • Interest Charges: €9 million
   • Interest Cover: $$\frac{18 \text{ million}}{9 \text{ million}} = 2$$

In these examples, Company A has a stronger financial position regarding interest obligations compared to Companies B and C.

Frequently Asked Questions§

Q1: Why is interest cover important?

• A1: Interest cover is essential because it helps investors and analysts assess a company’s ability to meet its financial obligations. A higher ratio indicates that a company is more capable of covering its interest expenses, reflecting financial stability.

Q2: What can a low interest cover indicate?

• A2: A low interest cover ratio suggests that the company may struggle to meet its interest obligations, increasing its vulnerability to financial distress, especially if interest rates rise or earnings decline.

Q3: How does interest cover relate to gearing?

• A3: Interest cover is closely related to gearing, a measure of financial leverage. Highly geared companies often have lower interest cover ratios, indicating higher financial risk due to greater debt.

Q4: Can interest cover change over time?

• A4: Yes, interest cover can change annually or even quarterly, reflecting changes in a company’s earnings, interest expenses, or both. Monitoring changes in this ratio over time can provide insights into a company’s evolving financial health.

Related Terms and Definitions§

• EBIT (Earnings Before Interest and Tax): A measure of a company’s profitability that excludes interest and income tax expenses.
• Gearing: A financial ratio comparing a company’s debt to its equity, indicating financial leverage.
• Debt Service Coverage Ratio (DSCR): A ratio measuring a company’s ability to service its debt, comparing net operating income to total debt service obligations.

Online References§

1. Investopedia - Interest Coverage Ratio: Investopedia
2. Corporate Finance Institute - Interest Coverage Ratio: CFI
3. The Balance - Interest Coverage Ratio: The Balance

Suggested Books for Further Studies§

1. “Financial Statement Analysis and Security Valuation” by Stephen Penman: Provides an in-depth exploration of financial ratios, including interest cover.
2. “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen: Covers principles of corporate finance, including key financial ratios.
3. “Fundamentals of Financial Management” by Eugene F. Brigham and Joel F. Houston: Offers a comprehensive overview of financial management principles, including the analysis of financial ratios.

Accounting Basics: “Interest Cover” Fundamentals Quiz§

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