Interest protection ratio is a measure of the minimum ratio between debt and assets which a business must adhere to in order to remain in solvency. It is an important concept for lenders and creditors as, by measuring it, they can get a quick assessment of the business’s ability to honour its debt obligations.
Interest protection ratios (also known as equity capital ratio) are expressed as a percentage of the amount of debt-to-asset. The higher the ratio, the more secure the creditor’s funds and the more likely they will be repaid. To calculate a business’s interest protection ratio, divide the amount of the loan or other debt (net of discount) by the total amount of the company’s assets.
For example, if the company has total assets of $10,000 and total debt (net of discounts) of $2,500, the Interest Protection Ratio (IPR) would be 25%. This ratio can then be used to determine the business’s level of solvency. Generally, lenders and creditors would be relatively comfortable if the IPR is above 25%.
The interest protection ratio is often used as a way to evaluate credit risk of the borrower. It is an important indicator of whether the borrower has enough assets to cover their debt, giving the borrower an incentive to increase their IPR. Having a higher IPR increases the chances of the borrower securing more favourable terms on their loan, as lenders are likely to offer them lower interest rates and terms if they are confident that the debt can be easily repaid.
In addition to using the interest protection ratio as an indicator of credit risk, businesses can also use this ratio to assess their internal financial health. The higher the IPR, the more profitable and solvent the business is, as there is less of a risk that the business could be forced to default on their loans, meaning that their creditors will be more likely to be repaid.
Overall, the interest protection ratio is an essential indicator of the financial health of businesses, providing creditors, lenders and investors with an additional tool to assess the solvency of a business. It is also an important tool for businesses to use when assessing their own financial health, allowing them to make informed decisions regarding their financial situation.
