The interest coverage ratio is computed by dividing 1) a corporation's annual income before interest and income tax expenses, by 2) its annual interest expense.
To illustrate the interest coverage ratio, let's assume that a corporation's most recent annual income statement reported net income after tax of $650,000; interest expense of $150,000; and income tax expense of $100,000. Given these assumptions, the corporation's annual income before interest and income tax expenses is $900,000 (net income of $650,000 + interest expense of $150,000 + income tax expense of $100,000). Since the interest expense was $150,000 the corporation's interest coverage ratio is 6 ($900,000 divided by $150,000 of annual interest expense).
A large interest coverage ratio indicates that a corporation will be able to pay the interest on its debt even if its earnings were to decrease. A small interest coverage ratio sends a caution signal.
Since the interest coverage ratio is based on the net income under the accrual method of accounting, we recommend that you also review the cash provided by operating activities (which is found on the corporation's statement of cash flows) for the same time period.
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