Financial Definitions: Interest Coverage Ratio

When first investing in the stock market, there are many new financial terms. So many, in fact, that sorting through all of the new-to-you definitions can seem more than a little daunting. However, with a little time and determination, you can begin to discover exactly what some of these terms mean and how they can apply to your stock research and purchase plans. Let’s look at one of these definitions: the Interest Coverage Ratio.

What is Interest Coverage Ratio?

The term Interest Coverage Ratio is one of the many calculations that appear on a stock’s ratios and returns spreadsheet. This spreadsheet will give you the low down on a company’s overall health and will include everything from the Gross Profit Margin to the Current Ratio to the Leverage Ratio (among many, many other calculations).

Of course, as mentioned, the Interest Coverage Ratio is one of these calculations, and it can be very helpful in determining the company’s health. This ratio calculated as: EBIT divided by interest expenses, and it will tell you how easily the company can repay interest expenses on its debts – and therefore how much more likely it will be to stay in business. Generally, any Interest Coverage Ratio higher than 1.6 is considered safe, but some analysts prefer to see the ratio above 2.5.

Why is a High Number Good?

Well, the higher the Interest Coverage Ratio, the better the company is handling its money. Almost all companies must borrow cash at some point in the game, but they must do so with a plan of attack. Basically, the money that they borrow should be applied in areas where they will make more money. A bakery chain, for example, could borrow money to build a new store. When the store is up and running, it should bring in cash to help repay the debt overall and (in the case of interest coverage) the interest on that debt.

Let’s look at one of my personal favorites, General Mills (GIS). You will see the Interest Coverage listed as 5.9%. This is quite healthy for the food industry, and it indicates that General Mills has been borrowing money for the right reasons: to make more money.

Overall, the Interest Coverage Ratio is a great tool to determine a company’s health. However, this is not the only tool available on the ratios and returns spreadsheet, and the Interest Coverage Ratio should be coupled with the many other ratios and returns to best determine if the company is healthy on all fronts. Bottom line: it may be best to research all aspects of a business before purchasing stock.

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