In this first post about the interest cover ratio, I want to talk a little about one of those drivers of interest paid. Remember that the interest cover ratio is calculated by dividing EBIT by the amount of interest paid as shown in the income statement. The big problem with the ratio is that it’s looking back at the financial year (or whatever period is covered by the income statement) and there are a few things we need to keep in mind when we interpret that ratio
When we are considering a lending opportunity for a client we are looking to the future because that’s where we get repaid from. So, remembering that one of the drivers is the interest rate (because it has a direct impact on the amount of interest the client will actually pay) it’s probably sensible to think about what the interest rate will be for the client in the future.
I’m not suggesting that you’re going to be increasing the rate for the client, but where are we in the interest rate cycle? The rate you charge the client is based on a Prime or Base Rate which, in turn, is based on the central bank’s rate. An increase or decrease in that rate is going to affect the interest that a client has to pay and so will affect the ratio. What’s the future scenario for the interest rate? If it’s upwards that means more interest paid in the future and a declining interest cover ratio as a result.
In the next post, I’ll talk about the other driver of interest paid – overdraft usage.