It is also known as time-interest-earned ratio. This ratio measures the debt servicing capacity of a firm insofar as fixed interest on long-term loan is concerned, It is determined by dividing the operating profits or earnings before interest and taxes (EBIT) by the fixed interest charges on loans. Thus,
It should be noted that this ratio uses the concept of net profits before taxes because interest is tax deductible so that tax is calculated after paying interest on long-term loan. This ratio, as the name suggests: indicates the extent to which a fall in EBIT is tolerable in that the ability of the firm to service its interest payments would not be adversely affected, For instance, an interest coverage of 10 times would imply that even if the firm’s EBIT were to decline to one-tenth of the present level, the operating profits available for servicing the interest on loan would still be equivalent to the claims of the lenders. On the other hand, a coverage of five times would indicate that a fall in operating earnings only to up to one-fifth level can be tolerated. From the point of view of the lenders, the larger the coverage, the greater is the ability of the firm to handle fixed-charge liabilities and the more assured is the payment of interest to them. However, too high a ratio may imply unused debt capacity. In contrast, a low ratio is a danger signal that the firm is using excessive debt and does not have the ability to offer assured payment of interest to the lenders.