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A financial indicator called the interest coverage ratio is used to assess a company's capacity to pay the interest costs on its outstanding debt. By dividing a firm's earnings before interest and taxes (EBIT) by its interest expense, the ratio can be computed to determine how much income a company generates in relation to the interest payments it is required to make.
The likelihood of a company defaulting on its debt commitments is expected to be lower if it has a high-interest coverage ratio, which shows that it is making enough money to comfortably cover interest expenses. A corporation may struggle to make its interest payments and may be more in danger of default, however, if its interest coverage ratio is poor.
For investors, creditors, and lenders, the interest coverage ratio is crucial because it shows how well-capitalized a business is and how likely it is to be able to pay its debts. It can be used to track a company's performance over time or to compare the financial results of various businesses.
An organization's interest coverage ratio, for instance, would be 10 ($1 million / $100,000) if it had an EBIT of $1 million and an interest expenditure of $100,000. This demonstrates the company's strong financial situation because it means it makes enough money to pay its interest 10 times over.
