The interest rate for time, sometimes called the interest coverage ratio, is a coverage index that measures the proportional amount of income that can be used to cover interest expenses in the future.
In some aspects, the interest rate over time is considered a solvency index because it measures a company’s ability to make interest and debt service payments. Since these interest payments are usually made in the long term, they are often treated as a fixed and continuous expense. As with most fixed expenses, if the company can not make the payments, it could go bankrupt and cease to exist. Therefore, this relationship could be considered as a solvency relationship.
The relationship between interest earned is calculated by dividing income before interest and taxes on income by interest expense.
Both figures can be found in the income statement. Interest expenses and income taxes are often reported separately from normal operating expenses for solvency analysis purposes. This also makes it easier to find earnings before interest and taxes or EBIT.
The relationship of interest over time is expressed in numbers instead of a percentage. The index indicates how many times a company could pay the interest with its income before taxes, so, obviously, the largest indices are considered more favorable than the smallest ones.
In other words, a ratio of 4 means that a company earns enough income to pay its total interest expense 4 times. In other words, the income of this company is 4 times higher than the interest expenses of the year.
As you can see, creditors would favor a company with a much higher interest rate because it shows that the company can pay their interest when it comes due. Higher rates are less risky, while lower rates indicate credit risk.
Tim’s Tile Service is a construction company that is currently requesting a new loan to buy equipment. The bank asks Tim for his financial statements before they consider his loan. Tim’s income statement shows that he earned $ 500,000 of income before interest expenses and income taxes. Tim’s total interest expense for the year was only $ 50,000. The relationship of Tim’s earned interests would be calculated as follows:
Formula of interest rate earned
As you can see, Tim has a ratio of ten. This means that Tim’s income is 10 times higher than his annual interest expense. In other words, Tim can afford to pay additional interest expenses. In this sense, Tim’s business is less risky and the bank should not have problems accepting his loan.