What’s the Interest Coverage Ratio?
The interest coverage ratio measures a company’s capability to meet its interest payments based on its current pre-tax operating earnings. It is defined as follows:
EBIT stands for earnings before interest and taxes and represents the profits that a firm has generated from its day-to-day operations. We use EBIT since it reflects the available opreating earnings that the company would have to meet its interest payments.
Interest expenses include all kinds of interest costs that the firm has to incur as a result of previous borrowings. Generally speaking, a company can raise capital through equity or debt. The act of borrowing money is linked with a contractual commitment that requires the firm to pay interest to creditors over a certain time period. The amount of interest that the company had to pay within each measured time frame (quarterly or annually) is recorded as interest expenses on the income statement.
The interest coverage ratio essentially depicts how many times a company would be able to pay its due interest payments with its current operating earnings: An interest coverage ratio of 2 reflects would mean that the company has EBIT of two times its due interest expenses. The higher the interest coverage ratio, the more safely a firm will be able to meet its interest payments.
What Causes a Negative Interest Coverage Ratio?
The only real cause that can lead a company to have a negative interest coverage would be negative operating earnings.
If a company had interest expenses that were higher than its EBIT, the interest coverage would be below 1 but still remain positive. In this case, the firm would already likely find itself in financial struggle since, theoretically, it wouldn’t be able to pay back interest with current earnings.
Example
| EBIT | Interest Expenses | Interest Coverage | |
|---|---|---|---|
| Company A | $50 million | $30 million | 1.66 |
| Company B | $40 million | $50 million | 0.8 |
| Company C | -$20 million | $10 million | -2 |
Let’s suppose that company A has reported an EBIT of $50 million for the last fiscal year, whereas its interest expenses were $30 million. Dividing 50 by 30 would lead us to an interest coverage ratio of 1.66 which means that company A would have more than enough capital funds from its earnings to pay back interest. Company B, on the other hand, has interest expenses that would exceed its EBIT which would thus result in an interest coverage ratio of 0.8.
What Does a Negative Interest Coverage Ratio Mean?
A negative interest coverage ratio reflects a firm’s unprofitability, meaning that it doesn’t generate positive earnings from its operations in the first place but still has interest payments to make which might put the business into dangerous circumstances that can lead to potential bankruptcy.
Unprofitable companies that have difficulties in paying back their debt and interest, will mostly have to raise additional capital to continue their operations which will make it even more difficult for the business to overcome its financial distress as it only worsens the debt burden. That being said, a negative interest coverage ratio doesn’t necessarily signify that the business will go bankrupt straight away.
There has to be a clear distinction being made between earnings and cash flows. A company can be unprofitable at any given time, but still, may have the necessary cash flows to pay its interest expenses. This scenario can for instance occur because of non-cash charges such as depreciation that are deducted from revenue as part of operating expenses but don’t actually reflect any cash outflows.
Is a Negative Interest Coverage Always Disastrous?
Evaluating whether a negative interest coverage would be dangerous to the company or not, can be rather difficult unless we don’t dive deeper into the company’s particular circumstances. The answer usually depends on where a company finds itself within its business life cycle.
Mature companies, for instance, can have a long history of positive and stable earnings until an economic or company-related incident might suddenly impact their operations temporarily.
Exxon Mobil Corporation (XOM) is one of the largest oil companies in the world and explores, produces, transports, and sells oil and natural gas globally. In March 2020, the oil industry was particularly hit by the consequences of the global pandemic as oil prices plunged and turned negative over an extended time period.
As a result, the oil conglomerate reported a negative operating income of -$3.982 billion for its fiscal year of 2020:
Having a look at the history of Exxon’s earnings shows that the company generated substantially higher operating earning during the previous years. What’s also noticeable is that interest expenses, in general, are very small relative to the firm’s earnings with less than 7% of 2019 operating earnings.
According to the recent fiscal year’s interest coverage ratio, the company wouldn’t be able to pay due interest expenses with its 2020 earnings. However, the point is that it doesn’t have to because the business has plenty of cash to pay back interest even if it would be unprofitable for the next few years.
As the oil industry recovered steadily from the start of 2021, Exxon’s financial performance also showed strong quarters of positive earnings, which confirms the fact that the business had to encounter temporary financial distress.
Negative Earnings Are Not Uncommon for Young Companies
While young companies should primarily be funded through equity at the beginning of their life cycles (as they’re expected to be unprofitable in their first years of operation), their interest coverage can still be negative even if they have relatively small interest payments to make.
Just as in the example above, one way to further evaluate a company’s financial health would be to look at the history of its EBIT and interest expenses. When assessing the history of young but rapidly growing businesses we should be to notice revenues growing at a rapid pace until their operating income reaches the positive mark.
Dropbox Inc (DBX), for instance, reported negative operating income during its past fiscal years, whereas the business had very small amounts of interest payments to incur.
Dropbox’s negative interest coverage wasn’t an issue that was worth mentioning because the business had much higher amounts of cash (relative to the interest expenses) that it had previously raised through equity. The chart also shows that Dropbox’s interest expenses were tiny relative to revenues.
As the company continued to improve its margins from revenue growth, Dropbox reported its first positive operating earnings in 2020.
Conclusion
- In most realistic cases, a negative interest coverage can only be caused by a negative EBIT.
- A negative interest coverage ratio isn’t a positive sign, to begin with, but doesn’t necessarily forecast a firm’s incoming bankruptcy. Instead, it “only” illustrates that the business would not be able to pay its interest expenses with current operating earnings.
- Whether it has enough cash or not to actually settle those interest expenses can’t be answered with just the interest coverage ratio on its own and will mostly require a deeper look into the company’s financial circumstances.
