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.