Question

Hi Max. Thanks for sharing this great example! Excessive levels of debt can definitely be a red flag. While the company may have legitimate reasons for selecting debt financing over equity financing, too much debt can paralyze the company as they may fall into violation of their debt covenants and have difficulty meeting their financial obligations. Class, how might the interest coverage ratio be telling in this type of situation?

Answer 1

• Interest Coverage Ratio is calculated by using following formula

where, EBIT refers to Earning before Interest and taxes

• It gives the information about the firms ability to pay its interest and other fixed debts (if any)
• A high interest coverage ratio is a positive sign for the company. It indicates that it can easily pay its interest at any market condition (favourable or adverse).
• However, a lower interest coverage ratio indicates more debt burden and inefficient operations.