Interest Cover

The interest covers ratio is quantitative measure of the company’s ability to pay the interest on the debt. The interest coverage ratio the profits before interest and taxes divided by the interest expense on the long term debt in the company.

High interest coverage ratio vs Low interest coverage ratio

A high interest coverage ratio is more desirable than a low interest coverage ratio as it signifies a greater ability to pay the interest expenses on debt. If a company is not able to pay its interest obligations, creditors may call on the loans and this could trigger a bankruptcy. A low interest coverage ratio is the result of over indebtedness.

Options traders who foresee that a company may have to file for bankruptcy may buy puts options to capture the downside in the company’s stock price. As an example, if the interest coverage ratio of the company is 1.25, it means that the profits before interest and taxes need only fall by 20% before the company is unable to pay its interest on its debt. This company should be considered to be in risk of a possible bankruptcy. A company with an interest coverage ratio however would have no problems paying off its interest on its debt.

How does this information help option traders?

Very often, management has the ability to convince the public that the company is doing well. Verify what the management is saying against the financial statements of the company. A company with high debt levels and a low interest coverage ratio is a good candidate to take a short position on. On the flipside, a company which is undervalued, has low debt levels, a high interest coverage ratio and consistent earnings is a possible candidate for a long position in the stock to capture any upside to the stock price.

Read : Depreciation