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Interest Coverage Ratio: The New Watch-phrase
A simple accounting principle states that the health of a company can be determined, at a quick glance, by simply subtracting debt from assets. The CEO uses a more complicated method for sure, but they can still take a cursory look every now and again. What they are seeing is actually expected. As the economy slowed down, so did the asset worth of their companies. What failed to dissipate along with that shrinking asset base was the company's debt.
The fixed income market has shut the door on many of these companies, closing off the taps and the chance to carry forward that debt until better times. Those times for those companies are a fingers-crossed future.
The economy is recovering slowly, mostly as a result of the slight increase in productivity. Even as jobs continue to drag the anchor on explosive growth, or so the majority of financial cheerleaders are suggesting, the debt that was carried will be the truest lagging indicator.
The ability for a company to pay those debts back is measured by interest coverage ratio. Debt is booked as an expense. The measure most popularly used takes the company's interest expense and compares it to the company's income.
These ratios change between industries as can be expected, but if these two figures begin to find the balance at equal, you may have your first warning that trouble is looming. It doesn't mean that the CEO will be carted off in handcuffs or even that bankruptcy is in the future. But this is the future of junk bonds and may just help you hedge the risk of default.
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