Interest Coverage Ratio

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What is the Interest Coverage Ratio?

The interest coverage ratio, or ICR, is a financial metric used to assess a company's ability to pay interest on its existing debt. It is computed by dividing the earnings before interest and taxes (EBIT) of the business by the interest expense incurred over the course of the calculation.

The easier it is for the company to satisfy its interest payments and the lower the danger of lending money to it, the higher the ratio. A lower ratio indicates a higher level of debt burden and a higher likelihood of payment default for the company.

Why is the Interest Coverage Ratio important?

Interest Coverage Ratio is important since it shows a company's solvency and overall financial health. It displays the operating profit margin in relation to interest expense, indicating the company's capacity to pay down its debt.

A high ratio suggests that the business has good cash flow and a low default risk because it has adequate earnings to comfortably cover its interest payments. A low ratio suggests that the business is having trouble covering its interest costs, which raises the possibility of a weak cash flow and a high default risk.

Lenders, creditors, and investors who wish to evaluate a company's creditworthiness and profitability should also consider the interest coverage ratio. This ratio is used by creditors and lenders to set the terms and interest rates of bonds or loans that they give to businesses.

Because a high ratio lowers their exposure to default risk and raises the likelihood that they will be paid back, they prefer it. This ratio is used by investors to assess the risk and return of purchasing stock or debt securities from a company. A high ratio is preferred by them since it signifies a steady and expanding revenue stream for the corporation, which can sustain dividend disbursements and capital gains.

What is the formula for the Interest Coverage Ratio?

The formula for the Interest Coverage Ratio is:

Interest Coverage Ratio = EBIT / Interest Expense

Where:

EBIT = Earnings Before Interest and Taxes
Interest Expense = Interest Payable on any Borrowings such as Loans, Bonds, Lines of Credit, etc.

Another variation of the formula is using earnings before interest, taxes, depreciation, and amortization (EBITDA) as the numerator:

Interest Coverage Ratio = EBITDA / Interest Expense

Where:

EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization
Interest Expense = Interest Payable on any Borrowings such as Loans, Bonds, Lines of Credit, etc.

How to calculate the interest coverage ratio?

The company's earnings before interest and taxes (EBIT) must be divided by its interest expense for the specified period in order to get the interest coverage ratio. Operating profit, or EBIT, is what's shown on the income statement for the business. In the income statement, interest expenditure is also shown. It represents the interest that must be paid on any borrowings, including bonds, loans, and credit lines. 

Examples of interest coverage ratio

Let's look at some examples of how to calculate and interpret interest coverage ratios for different companies.

Company A 

Has an EBIT of $8,580,000 and an interest expense of $3,000,000. Its interest coverage ratio is:

Interest Coverage Ratio = $8,580,000 / $3,000,000 = 2.86

Based on this, Company A's operational profit can cover its interest payments 2.86 times. Given that the ratio is relatively low, the corporation likely faces challenges in satisfying its interest payments due to its substantial debt load.

Company B 

Has an EBIT of $15,000,000 and an interest expense of $2,000,000. Its interest coverage ratio is:

Interest Coverage Ratio = $15,000,000 / $2,000,000 = 7.5

This indicates that Company B's operational profit can cover its interest payments 7.5 times over. Given the comparatively high ratio, the business is able to pay its interest payments with ease and has a low debt load.

Company C 

Has an EBIT of $10,000,000 and an interest expense of $5,000,000. Its interest coverage ratio is:

Interest Coverage Ratio = $10,000,000 / $5,000,000 = 2

In other words, Company C's operational earnings may cover its interest payments twice over. The corporation has a moderate debt load and may have some difficulties paying its interest due, as indicated by this borderline ratio.

Limitations of interest coverage ratio

While the interest coverage ratio is a useful indicator of a company's debt servicing ability and financial health, it also has some limitations that should be considered when using it for analysis.

• Principal repayments of debt, which constitute a significant portion of a company's debt obligations, are not taken into account by the interest coverage ratio. Even with a high interest coverage ratio, a business could find it difficult to make timely principal payments on its debt.
• The interest coverage ratio does not take into consideration interest rate volatility, which might fluctuate over time based on the state of the market and the terms of debt agreements. When interest rates are low, a company's interest coverage ratio could be high, but when rates rise, the ratio will likely be lower.
• The sustainability and quality of earnings are not taken into consideration by the interest coverage ratio, as they might vary depending on a number of factors such accounting rules, economic cycles, and seasonality. If earnings are inflated or transitory, a company's interest coverage ratio may be high; but, if earnings stabilize or diminish, the ratio will fall.
• The interest coverage ratio fails to take into consideration the variations in business models and industries throughout organizations, which could impact the ideal debt and leverage ratio. Even though a company's interest coverage ratio is lower than that of its competitors, it can nevertheless turn a profit and run effectively.

FAQ

Credit rating agencies often use the ICR as one of the factors in determining a company’s credit rating. A higher ICR, indicating better ability to service debt, could contribute to a higher credit rating.

Yes, the ICR can be used to assess the financial health of non-profit organizations by measuring their ability to meet interest obligations. However, the interpretation of the ratio might differ due to the unique financial structure of non-profits.

Inflation can impact the ICR indirectly. If inflation leads to higher interest rates, the interest expense for a company may increase, reducing the ICR. Conversely, if a company can pass on inflationary pressures to customers via higher prices, it may increase earnings, potentially improving the ICR.

While both ratios are used to measure a company’s ability to service its debt, the ICR only considers interest expenses, while the DSCR takes into account both principal and interest obligations.

The choice of earnings measure can affect the ICR. Using EBITDA can result in a higher ICR because it adds back depreciation and amortization expenses, which are non-cash charges. This might be more appropriate for companies with significant depreciation and amortization. Using EBIAT (Earnings Before Interest After Taxes) takes into account the impact of taxes on the company’s earnings.