Fundamental Analysis: Funda 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. Feel free to give me a comment about this topic. It will be a great support to Xaivier Blog.

Written by: Xaivier Chia

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

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