Interest Coverage Ratio – Do You Earn Enough Revenue?

Do You Know about the damage caused by Interest Coverage Ratio during the covid-19 pandemic?

It swallowed many smaller hotels and restaurants during the pandemic.

You are giving me that baffled look.

What has interest coverage ratio got to do with covid-19, you ask?

Awesome question.

The answer may shock you.

However, not to worry.

I have got you covered.

However, first, take a look at the simple animated graph of two lines below:

We will shortly understand what it is all about.

And why it was a deadly factor during covid-19.

I will clarify in simple terms everything you should know about this powerful ratio.

And you need not worry about businesses getting swallowed!

Along the way, we will answer questions like:

• What is a good interest coverage ratio?
• Interest Coverage Ratio Formula
• Interest Coverage Ratio Interpretation

and more...

However, let us take a step back to understand key concepts related to this mysterious interest coverage ratio.

This Blog Post will cover:

What If Revenue Decreases or Worse Runs Dry?

This is something that happens regularly in a hotel operation.

Assume it is a slow month for your hotel.

You are running 30% occupancy.

Revenue is obviously much lower than say a month of 70% occupancy.

You notice this much only.

However, is that all?

As an operations manager you may not know something else happening in your financial statement

Something that is critical to the running of your hotel.

A factor that has the potential of causing long term damage to your hotel reputation.

You are totally at a loss as to what I am talking about.

Enough of the suspense.

Click to go back to the simple animated graph we saw earlier.

Revenue is Oxygen for Your Hotel Business

Revenue is like oxygen.

Ca you imagine a situation where the oxygen in the air disappears.

You will stop breathing!

The same thing happens when revenue dries up.

Your hotel business will stop breathing (aka stop running).

Why is that, you are curious to know?

Indeed, I am coming to that.

Revenue → Cash Flow Connection

As a Hotel Operations Manager, you only see the Profit and Loss Statement with 30% occupancy.

And low revenue.

But there is much more your hotel is going through.

Low revenue has one immediate effect.

You may not have realized that.

Revenue generates cash flow.

In other words, earning revenue creates cash resources with which the business can run.

When revenue decreases or stops, cash flow will also decrease or stop.

And so will the business.

It is not that if revenue stops or decreases for a day, the business will stop running.

However, sustained revenue decrease will lead to that.

How, you want to know?

When cash flow decreases, your hotel may not be able to keep up its obligations.

One key obligation is to pay interest and installments for the loan taken by the hotel.

Almost every hotel in business has an element of borrowing for which it must fulfill obligations.

Now, let me explain the graph (at last, you say!).

Animated Graph on Interest Coverage Ratio

Take a look at the animated graph again.

What does the flat horizontal line represent?

It represents fixed financial costs that the hotel must incur.

Interest on loan taken is probably the most important fixed financial cost.

However, here is the kicker.

Whether you run 30% or 90% occupancy, you MUST pay interest costs.

The lender does not really care what level of occupancy you are running.

They expect their monthly interest costs to be paid without fail.

That is why the financial cost line is horizontal or fixed.

Now, let us relate this situation to the graph.

First, notice how the fixed financial cost line runs through the earnings curve.

Second, the earnings line represents profit earned from revenue generated.

Third, the earnings line is sometimes below and sometimes above the fixed financial cost line.

What does this mean?

Explanation coming right up.

Fixed Financial Costs Vs Earnings

It means that:

• in months of low occupancy, 
• the hotel profit (which equates to cash flow) 
• is less than the fixed financial cost.

In other words, cash flow generated is not enough to pay the interest cost.

This situation may be a one off thing.

However, it can also be something that repeats itself.

Particularly, when occupancy is very low and revenue and profit are also low.

If low occupancies continue month after month, the hotel is in a deadly cash crunch.

It cannot pay its loan interest consistently.

This may lead to a phenomenon called foreclosure.

Foreclosure means the lender will take possession of the hotel assets.

So that, they can sell those assets and recover their outstanding loan amount.

Effectively the business will fold.

This is what happened during covid-19.

Let me explain.

The Covid-19 Revenue Crunch

The hospitality business model is a unique one.

It is seasonal to begin with.

Meaning, business volumes differ from month to month.

Hotels strive to keep the revenue graphs on an upward trend as much as possible.

This is while they are battling the phenomenon of fixed financial costs (animated graph).

A hotel goes through annual cycles of high, low and moderate volumes of monthly business.

Occupancies are barometers of hotel business volumes.

A hotel can reach occupancies of above 90% (and a full house too on select days) in peak months.

Low months however are huge challenges for the hotel business.

With occupancies dipping below the 40% mark, revenue shrinks.

As a result, profit and cash flow also shrink.

An ongoing hotel strategy is to drum up extra volume (at high commission costs often) during low months.

So that the overall revenue graph does not dip!

And profit and cash flow are maintained.

Fixed financial costs (interest cost) turn into an advantage during high occupancy months.

Because they are covered many times over by substantially high revenue.

However, they depress revenue (and cash flow as well) in months of low occupancies.

Covid-19 saw even giants like Marriott running single digit occupancies.

However, by virtue of their pre-eminent financial standing, they were able to weather the storm with cash flow reserves.

Smaller hotels and restaurants did not have that luxury.

For them, revenue shrank alarmingly. 

And continuously over 24 months.

They had no cash flow to pay loan interest costs.

Foreclosure inevitably happened.

What is a Good Interest Coverage Ratio?

So, the moral of the story is to keep the revenue graph steady if not peaking all the time.

As long as your revenue is at a level generating enough profit and cash flow you are safe.

How would you know if your hotel is not in danger of foreclosure?

Well, you need to compare your hotel earnings (profit) with the interest cost you are incurring.

The higher the number of times interest cost is covered by earnings the better.

This means earnings need to be boosted by higher revenue.

In turn, revenue will be boosted by higher occupancy and a reasonable average daily rate.

So, a good interest coverage ratio will depend on level of interest cost as well as earnings.

Let us first see the formula for a Interest Coverage Ratio.

Interest Coverage Ratio Formula

Take a look at the infographic below.

Pay attention to the third ratio in the below infographic.

Now let us learn what an Interest Coverage Ratio is.

The Interest Coverage Ratio formula is straight forward.

It compares earnings with interest cost.

The formula is:

Earnings Before Interest, Taxes, Depreciation, Amortization [EBITDA] divided by Interest Cost.

Or EBITDA / Interest Cost

Earnings are commonly known by the acronym EBITDA.

Hotel Owners lay store majorly on EBITDA.

This is because this profitability measure indicates level before fixed financial cost and others kick in.

You could say the EBITDA is a form of Net Operating Profit.

Interest Coverage Ratio as a Solvency Ratio

Interest Coverage Ratio is a Solvency Ratio.

What is a Solvency Ratio?

Solvency Ratios are indicators of the long term health of a business.

They give you hints at the sustainability of a business.

You saw in the earlier post in this series about debt equity ratio.

Debt Equity Ratio is an indicator of the long term health of a business.

Interest Coverage Ratio is closely related to Debt Equity Ratio.

The “debt” in the Debit Equity Ratio is the one on which “interest” in the Interest Coverage Ratio is calculated.

How is Interest Coverage Ratio Useful?

An Interest Coverage Ratio of over 4 is generally considered good.

This means earnings are more than 4 times interest expense.

Remember that in order for earnings (profit) to be good, first revenue must be healthy.

If say, revenue decreases and thereby earnings (profit), the interest coverage ratio will become less than 4.

An earnings decrease that brings an interest coverage ratio to less than 1 or 1.5 is dangerous.

How so, you ask?

This is because the cushion for earnings to cover interest cost is the minimum.

Any further drop in earnings will mean there is very little room.

There is a risk that the hotel may default in its loan interest payments.

This can mean danger to the survival of the business itself.

In general, higher the interest coverage ratio the better the solvency.

Interest Coverage Ratio along with Debt Equity Ratio are two of the best indicators of solvency.

Solvency is one of the key measures of long term sustainability.

Or, how solvent is the hotel?

So, they are able to provide the cash necessary to pay interest cost on long term debt

This is the reason the the Interest Coverage Ratio is critical.

Reasons Your Interest Coverage Ratio Could be Alarming

What are some reasons you could avoid being in a situation of low interest coverage ratio?

First, manage your revenue well.

Revenue is the foremost priority for a business.

It leads to improved earnings or profit (if expenses are managed well) and is critical for liquidity.

While they boost liquidity, it also helps in solvency.

Second, manage your debt or borrowings, which are simply long term liabilities.

Generally, debt should not be more than 65% of total financing for a hotel.

Debt is thus not causing too much pressure on earnings.

Third, balance your revenue with your expenses.

This will lead to better earnings or profit.

Profit will build retained earnings which will improve owner equity.

Improved owner equity will reduce pressure of long term debt on the business.

Further you must ensure that you do not fall prey to some traps stated below.

Traps You Must Avoid with Interest Coverage Ratio

As we have said earlier, financial ratios are mere indicators.

It is critical that we understand how they are calculated.

Earnings and Interest Cost play a part in this ratio.

So, both revenue and profit must be taken into account.

Similarly, level of long term debt must also be considered (not more than 65%).

These movements have to be monitored each month and year.

You must therefore keep an eye on the overall long term borrowing and earnings closely.

This is to ensure they do not spiral out of control.

Big Picture of Solvency Ratios

At the end of the day, you must step back and take a big picture overview of solvency.

Meaning, look at the solvency picture in entirety.

And not just look at:

• revenue or profit on the one hand and
• interest on long term debt on the other

in isolation.

The big picture will be how solvent the business is.

This means a healthy Interest Coverage Ratio.

That will allow you to run your hotel operation without any sustainability doubts.

Chapters in this Ultimate Guide on Hotel Financial Ratios

This Ultimate Guide is a twelve part series which will cover the following key areas:

• CHAPTER 1 of 12 - Hotel Financial Ratios - Why should you care? [Already Published]
• CHAPTER 2 of 12 -Liquidity Ratios Intro - Acid Test Ratio [Already Published]
• CHAPTER 3 of 12 -Liquidity Ratios - Accounts Receivable Turnover Ratio [Already published]
• CHAPTER 4 of 12 -Liquidity Ratios - Working Capital [Already Published]
• CHAPTER 5 of 12 -Solvency Ratios - Net Worth [Already Published]
• CHAPTER 6 of 12 -Solvency Ratios - Debt Equity Ratio
• CHAPTER 7 of 12 -Solvency Ratios - Interest Coverage Ratio [This Post].
• CHAPTER 8 of 12 -Activity Ratios - Inventory Turnover Ratio
• CHAPTER 9 of 12 - Profitability Ratios Intro - Gross Operating Profit
• CHAPTER 10 of 12 - Profitability Ratios - Return on Investment Ratio
• CHAPTER 11 of 12 - Profitability Ratios - Return on Equity Ratio
• CHAPTER 12 of 12 - Asset Management Ratios Intro - Asset Turnover Ratio, RevPAR / Wrap Up: How to Identify Warning Signs in Hotel Financial Ratios

Next Friday

We will dive into the eighth of hotel financial ratios - Inventory Turnover Ratio

We will see:

• What is inventory turnover?
• Meaning of Inventory Turnover?
• Why is Inventory Turnover Ratio considered so critical? (With an illustration)
• How do you read and use inventory turnover ratio?

and more…

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