How to Use Financial Reports to Calculate the Interest Coverage Ratio
The interest coverage ratio looks at income on financial reports to determine whether the company is generating enough profits to pay its interest obligations. If the company doesn’t make its interest payments on time to creditors, its ability to get additional credit will be hurt; eventually, if nonpayment goes on for a long time, the company may end up in bankruptcy.
The interest coverage ratio uses two figures that you can find on the company’s income statement: earnings before interest, taxes, depreciation, and amortization (also known as EBITDA); and interest expense.
How to calculate the interest coverage ratio
Here’s the formula for finding the interest coverage ratio:
EBITDA ÷ Interest expense = Interest coverage ratio
Calculating this ratio may or may not be a two-step process. Many companies include an EBITDA line item on their income statements. If a company hasn’t included this line item, you have to calculate EBITDA yourself.
Mattel reports operating income before it lists its interest and tax expenses. Mattel doesn’t have a line item for amortization or depreciation, so you need to look at the cash flow statement to find that amortization totaled $16,746,000 and depreciation totaled $157,536,000. Therefore, in Mattel’s case, EBITDA was $945,045 (Income before taxes) + $16,746,000 + $157,536,000 = $1,119,327,000. Then, to get the interest coverage ratio:
$1,119,327,000 (EBITDA) ÷$88,835,000(Interest expense) = 12.60 (Interest coverage ratio)
Thus, Mattel generates $12.60 income for every $1 it pays out in interest.
Hasbro reports amortization expenses of $50,569,000 on the income statement. It also reports $99,718,000 for depreciation of plant and equipment on the statement of cash flows, so you need to add those expenses back in to find the EBITDA:
$453,402,000 (Income before taxes) + $50,569,000 (Amortization on income statement) + $99,718,000 (Depreciation of plant and equipment) = $603,689,000 (EBITDA)
$603,689,000 (EBITDA) ÷$91,141,000 (Interest expense) = 6.62 (Interest coverage ratio)
Hasbro generates $6.62 for every $1 it pays out in interest.
What do the numbers mean?
Both companies clearly generate more than enough income to make their interest payments. A ratio of less than 1 means a company is generating less cash from operations than needed to pay all its interest.
Lenders believe that the higher the interest coverage ratio is, the better. You should be concerned about a company’s fiscal health anytime you see an interest coverage ratio of less than 1.5. This means the company generates only about $1.50 for each $1 it pays out in interest. Any type of emergency or drop in sales may make it difficult for the company to make its interest payments.