Creditors are interested to know if a company can pay its long-term debts. There are several ratios we use for this as demonstrated in the video:
Debt ratio The debt ratio measures how much we owe in total liabilities for every dollar in total assets we have. This is a good overall ratio to tell creditors or investors if we have enough assets to cover our debt. The ratio is calculated as:
Times interest earned ratio Creditors, especially long-term creditors, want to know whether a borrower can meet its required interest payments when these payments come due. The times interest earned ratio, or interest coverage ratio, is an indication of such an ability. It is computed as follows:
|Income from operations (IBIT)|
The ratio is a rough comparison of cash inflows from operations with cash outflows for interest expense. Income before interest and taxes (IBIT) is the numerator because there would be no income taxes if interest expense is equal to or greater than IBIT. (To find income before interest and taxes, take net income from continuing operations and add back the net interest expense and taxes.) Analysts disagree on whether the denominator should be (1) only interest expense on long-term debt, (2) total interest expense, or (3) net interest expense. We will use net interest expense in the Synotech illustration.
For Synotech, the net interest expense is $236.9 million. With an IBIT of $1,382.4 million, the times interest earned ratio is 5.84, calculated as:
|Income from operations||$1,382.40|
The company earned enough during the period to pay its interest expense almost 6 times over.
Low or negative interest coverage ratios suggest that the borrower could default on required interest payments. A company is not likely to continue interest payments over many periods if it fails to earn enough income to cover them. On the other hand, interest coverage of 5 to 10 times or more suggests that the company is not likely to default on interest payments.