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The formula for the interest coverage ratio is used to measure a company's earnings relative to the amount of interest that it pays. The interest coverage ratio is considered to be a financial leverage ratio in that it analyzes one aspect of a company's financial viability regarding its debt.
One consideration of the interest coverage ratio is that earnings can fluctuate more than interest expense. It is important to look at prior trends of a particular company as the interest coverage ratio does not consider future projected earnings. In addition, as with any financial formula, no one ratio or formula should be used in isolation.
The variable EBIT in the interest coverage ratio formula stands for earnings before interest and taxes. EBIT is also referred to as operating income, which is revenues minus operating expenses. Interest expense refers to the amount of interest the company pays on its debt.
Both EBIT and interest expense can be found on a company's income statement.
Internally, a company may use this formula to review its ability to meet its obligations.
An investor may consider a company's trend in borrowing, revenues, expenses, and assets. The formula shown for the interest coverage ratio would bring one piece of the puzzle by evaluating a company's debt expense and revenue. An investor in bonds or a lender may pay more attention to a company's financial leverage to determine the likelihood of meeting its debt obligations.