One way analysts measure the ability of a company to meet its obligations is to calculate the times interest earned ratio for any outstanding debt the company may have. How would a company with $100,000 of outstanding bonds paying 8.5% annually and income before interest and taxes of $50,000, calculate the interest coverage (accrual basis) ratio?

Question

Quizplus · Accepted Answer

The interest coverage ratio, also known as the times interest earned ratio, is a financial metric used to determine how easily a company can pay interest on its outstanding debt. The formula to calculate the interest coverage ratio is:
Interest Coverage Ratio = Income Before Interest and Taxes (EBIT) / Interest Expense
Given the information provided:
- The company has $100,000 of outstanding bonds.
- The bonds have an annual interest rate of 8.5%.
- The company's income before interest and taxes (EBIT) is $50,000.
First, we need to calculate the annual interest expense on the bonds:
Interest Expense = Outstanding Bonds x Annual Interest Rate
Interest Expense = $100,000 x 8.5%
Interest Expense = $8,500
Now, we can calculate the interest coverage ratio:
Interest Coverage Ratio = EBIT / Interest Expense
Interest Coverage Ratio = $50,000 / $8,500
Interest Coverage Ratio ≈ 5.88
Therefore, the interest coverage ratio for the company is approximately 5.88. This means that the company can cover its annual interest expense about 5.88 times with its income before interest and taxes.
The correct answer to the question is:
a. Income before interest and taxes divided by the interest expense.

One Way Analysts Measure the Ability of a Company to Meet