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Type of Securities Investment Strategies Fundamental Analysis Technical Analysis
Introduction to Fundamental Analysis Income Statement Analysis Balance Sheet Analysis Cash Flow Analysis Shareholders' Equity Analysis Ratios and Definitions


Income Statement Analysis

 - Great companies and good
    EPS growth do not guarantee
    stock market profits

 - The P/E ratio can create
    buying opportunities


 - Mishaps can create steals

 - Unusual charges reduce the
    value of your stock

 - ROE is the single best tool
    for investors

 - ROA is another valuable tool

 - Investors pay for high profit
    margins

 - Lenders can eat up all the
    profits

 - Depreciation creates
    deferred taxes, which have
    equity-like qualities


 - EPS is a complicated
    calculation

 

 


Lenders can eat up all the profits

The interest coverage ratio measures how many times cash flow can be used to cover interest expense. It is calculated by dividing EBIT (earnings before interest and taxes) by interest expensed. Naturally, the higher the multiple, the better the position for the company.

Many professionals feel that a 1.5 times or greater multiple is safe. A multiple of under one times, however, indicates that the company may be unable to make interest payments. The bank’s covenant agreements will set the minimum multiple. If the company’s financial results fall below the bank’s requirements, the company will be in default of its covenants, and the bank can call the loan. This is a very serious issue for banks, since they have to follow the non-accrual reporting requirements that are mandated by the Federal Reserve. 

However, the bankers’ minimum interest coverage multiple is too low for equity investors. If the interest coverage ratio just supports paying interest, then there is no cash flow left to build shareholder value, or to pay dividends. The company may also be unable to fund future growth opportunities.  It’s positive cash flow that builds value for shareholders. If there is little cash flow left after paying interest, then the company is effectively working for and controlled by the lenders, not the shareholders. 

Additionally, the interest coverage ratio ignores loan principle payments. A company may be fine based on the interest coverage ratio, but might not be able to make required principle debt payments as they come due.

The interest coverage ratio is a key element in a company’s overall debt service coverage, and should be closely monitored by investors. There needs to be sufficient cash flow to cover the lenders’ requirements and to provide an adequate return for shareholders. The upside for the equity holders is limited when lenders receive all the cash flow.

 

 

 

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