How is the interest coverage ratio calculated?

The interest coverage ratio is a financial metric used to assess a company's ability to pay interest on its outstanding debt. It measures how easily a company can meet its interest obligations with its earnings. The formula for calculating the interest coverage ratio is to take earnings before interest and taxes (EBIT) and divide it by interest expenses.

Using EBIT is critical because it reflects a company's operating performance without the effects of financing and tax structure, thus giving a clearer picture of its ability to cover interest payments. A higher interest coverage ratio indicates that a company is more capable of handling its debt obligations, while a lower ratio may suggest financial stress.

The other options do not directly relate to assessing a company’s ability to pay interest. Total revenue divided by total liabilities looks at revenue generation capacity relative to total obligations, rather than focusing on interest payments. Net income divided by total equity provides insight into profitability relative to shareholder equity, while cash flows from operations divided by interest payments gives a liquidity perspective but is not the standard formula used for the interest coverage ratio. Therefore, the correct choice emphasizes the operational earnings in relation to debt servicing costs, correctly reflecting the purpose of the ratio.