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Financial Ratios and Their Effect on Interest Expense Ratios

by gbaf mag
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The interest coverage ratio, also known as the credit ratio, is an important part of the equation for many small businesses. It’s the tool companies use to determine if a business can service its debt payments on time. It’s one of several financial ratios used to assess a company’s overall financial health. Investors and market analysts consider a good interest coverage ratio crucial, because a business can’t grow or otherwise survive unless it’s able to pay its debt on time. Let’s look at what this means in a little more detail.

The interest coverage ratio measures how much debt a business can realistically pay back on its own. That assumes it has enough cash on hand to make all its monthly payments. When businesses do get some cash flow, it’s usually from selling assets or using some of the money equity creates to pay back some of their debt. In either case, they still have obligations left that must be paid back.

There are two main ways to calculate this ratio, and they’re both effective. One uses closing balance, which simply means the total amount of cash paid back divided by the total amount owed. The other method uses a mathematical formula that takes the yearly interest paid and the current interest rate to arrive at a times interest earned figure. Both are very good tools for evaluating a business’s ability to pay back debts, but there’s one important difference.

In calculating the interest coverage ratio, the current interest rate is not factored into the equation. That’s why it’s called the closing balance. The purpose of the calculation is to calculate how much a company may be able to pay based on its current assets and liabilities, and whether or not those assets and liabilities will cover their interest obligations over the term of the loan. It can also help an investor or business owner to evaluate if they are being charged an excessive interest rate. This is why most business debt analysts will include the closing balance in their analysis.

What are the factors that go into determining the interest coverage ratio? First, you need to look at the financial commitments of the company. These include the amount of money needed to finance equipment and property, and the amount of money needed to pay interest on those assets and liabilities. Any financial commitments above the stated minimums must be included in the calculation.

Then, the businesses’ cash flow and its interest coverage ratio are calculated. The ratio used is the annual debt ratio, which is the annual debt used against current assets. Remember that the debt ratio only considers current assets; any long term investments would not be included. Any tangible assets, the company possesses that could be sold must be accounted for in this ratio. One exception to this is if the company could generate a small profit, but chooses to hold its stock instead.

Lastly, and probably most importantly, any financial projections are done according to the standard deviation of the interest coverage ratio. This means that the deviation is the standard deviation of the overall average interest rate applied to the entire company. Because of this important variable, many financial ratios will also consider seasonal adjustments. If the company has a very high or low ebit interest expense, it may be reasonable to consider a seasonal adjustment to the total.

Of course, many times companies have excellent past ebit earnings, but a high interest coverage ratio. In those cases, the best solution may be to lower the overall interest expenses. This could be accomplished by reducing overhead, or cutting back on the number of loans the company takes out. However, those companies that have lower than average ebit earnings may still want to use the standard deviation to account for the fact that their overall profitability is suffering from the high interest costs.

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