The interest coverage ratio is a debt-to-profitability ratio that determines how readily a firm can pay interest on its debt. Divide a company’s earnings before interest and taxes (EBIT) by its interest expenditure for a particular period to get the interest coverage ratio.
The time’s interest earned (TIE) ratio is another name for the interest coverage ratio. This method is frequently used by lenders, investors, and creditors to assess a company’s riskiness in relation to its existing debt or prospective borrowing.
Interest Coverage Ratio= EBIT/Interest Expense
The Interest Coverage Ratio (ICR) is a financial ratio that is used to determine how well a company can pay the interest on its outstanding debts. The ICR is commonly used by lenders, creditors, and investors to determine the riskiness of lending capital to a company. The interest coverage ratio is also called the “times interest earned” ratio.
A low interest coverage ratio means a higher probability of default and a relatively lower rating, which increases the perceived risk in the company’s ability to pay to its debtors
This increased risk raises the cost of capital. Since, value of a company or an asset is the present value of its future cash flows. (The future cash flows to a firm are discounted using the cost of capital) A higher cost of capital increases the discounting and therefore decreases the present value of the company or simply put, the valuation of the company drops!