06 September 2010

Fundamental Analysis: Interest Coverage Ratio: Interest Expense to Net Profit Ratio

Interest Coverage Ratio is used to assess the possibility of a company to be bankrupt. The higher the ratio of interest expense to net profit, the higher the possible the company is going to be bankrupt.

This is a very simple step but can help you protect your investment fund. Please always treat this as your first step before carrying out other complicated evaluation methods such as ROA, ROE etc.

Think about what will happen if Company Y has Interest Coverage Ratio equals to 0.5 or 50%. This means half of the total net profit of the company is used to pay its interest expense. Besides, one should bear in mind that the interest expense is not going to be reduced as long as the debt is not paid off.

The situation above is very risky since the company must mention its profit in order to pay their interest expense. In the meanwhile, if the some of the company long-term debt is expired. I have no idea how the company can cover it in the coming year.

To conclude, please avoid investing a company with high Interest Coverage Ratio unless you are well understand why the interest coverage ratio is high and sure this company can handle the situation I have mentioned above. That's all for today. More fascinating articles and sharing will be updated from time to time in Xaivier Blog. So, you are welcome to subscribe our feed, look at our sitemap or simply visit our Homepage.

Written by: Xaivier Chia

Reference: http://beginnersinvest.about.com/od/incomestatementanalysis/a/interest-coverage-ratio.htm



chinshengji said...

Hi there,
Shouldn't it be: "The higher the ratio of interest expense to net profit, the lower the possible the company is going to be bankrupt."

Xaivier Chia said...

"higher the ratio of interest expense to net profit" means the amount of interest expense is a lots compared to net profit. So, could you imagine that most of the money you earned is for paying interest? Say profit of 5, 3 is for interest, then your net profit is only 2, with the ratio of 3/2.

chinshengji said...

Ah i see. I calculated interest coverage ratio by dividing net profit with interest expense. Sorry, my bad.. Thank you. :)

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