What is the Interest Coverage Ratio? Definition, Formula & Example
Have you ever been weighed down by how an entity easily pays off its interest? If a firm stood for a person, then the Interest Coverage Ratio (ICR) is a basic health check to determine whether it’s just about making ends meet or can comfortably pay the interest on its loans every month.
Consider the flashlight that illumines a room: a flashlight that gets switched on instantly is used in the case of the Interest Coverage Ratio by lenders, investors, and financial analysts to find out whether a company, rather than a concern, is an impending debt trap or financially sound. The larger the ratio, the more secure-looking it is for the company; the lower the ratio, the more concerning.
Keeping in mind that this critical financial measurement must be understood, for students, business owners, or investors with a keen interest, in this blog, we will walk you through what the Interest Coverage Ratio is, its calculation, exact formula, and an example in real-world terms.
What is a Good Interest Coverage Ratio?
The interest coverage ratio is a financial symptom that measures the number of times interest charges are payable from earnings before interest and tax.
In simple terms, the interest coverage ratio is an indicator showing how well a business can pay interest out of loan proceeds. Another name for this ratio is” times interest earned.”
It must be mentioned that paying the principal is not the concern here. Interest coverage ratio concerns itself specifically with a company’s capability to pay interest on its debts.
How to Calculate Interest Coverage Ratio
A company’s earnings before interest and taxes are divided by its interest expenses for the same period to determine the interest coverage ratio.
Lenders, creditors, and investors use the interest coverage ratio formula frequently to determine the risk of providing money to a certain company. Evaluating the aforementioned company’s profitability is also beneficial.
The formula for this ratio is:
Interest Coverage Ratio = Earnings before Interest and Taxes or EBIT/ Interest Expense
or,
Interest Coverage Ratio = EBIT + Non-cash expenses / Interest Expense
Formula of Interest Coverage Ratio
The following formula is used to get the interest coverage ratio:
Formula: Interest Coverage Ratio
Interest Coverage Ratio = Earnings before interest and taxes (EBIT)
——————————————————-
Interest Expense
Where:
- The profit from operations is EBIT (Earnings Before Interest and Taxes).
- Interest expenditure represents the interest expenses an entity pays on any borrowings, whether bonds, loans, credit lines, etc.
Earnings before expenses such as depreciation, amortization, and interest can be used as another numerator in the formula:
Interest Coverage Ratio = EBITDA / Interest Expense
Types of Interest Coverage Ratios
Otherwise, the interest coverage ratio can be constructed in many ways. It could be based on interest and taxes and include depreciation and amortization gross of capital expenditure or EBIAT, fixed charge, and EBITDA.
- EBITDA Interest Coverage Ratio
The Interest Coverage Ratio measures the times of EBITDA in covering Interest Expense.
- Fixed Charge Coverage Ratio
FCCR determines the company’s capacity to pay all of its short-term financial obligations.
- EBITDA Less Capex Interest Coverage Ratio
You could determine his ratio from the understanding of how often EBITDA can compensate for interest payments after capital expenditures have been made.
- EBIAT Interest Coverage Ratio
Alternatively, EBIAT can stand for earnings before interest and taxes. In this regard, it provides a clear indication of the business’s ability to cover interest on loans.
Interest Coverage Ratio Interpretation
Lower interest coverage makes the company more susceptible to debt and bankruptcy. There being a diminished ratio, the company might be exposed to interest rate fluctuations, with less operating income to cover interest payments. Accordingly, the higher interest coverage ratio represents an excellent financial position of the company and its ability to pay interest.
Contrarily, a higher ratio also implies that the company is forgoing opportunities of using leverage to increase profits. Generally, companies with stable cash flows and revenues rarely tolerate an ICR exceeding 2. In some situations, analysts prefer an ICR that exceeds 3. When the ICR is less than 1, poor financial health is indicated, implying that the business cannot pay off its interest debt that is short-term in nature.
Example of Interest Coverage Ratio
Let’s use this ratio to compare the EBIT of two businesses, ABC Co. and XYZ Co.
1) Company EBIT:
| Company | 2015 | 2016 | 2017 | 2018 | 2019 |
| ABC Co [EBIT] | 9000 | 10000 | 12000 | 14000 | 15000 |
| XYZ Co [EBIT] | 9000 | 10000 | 12000 | 14000 | 15000 |
2) Company Interest:
| Company | 2015 | 2016 | 2017 | 2018 | 2019 |
| ABC Co | 3350 | 3400 | 3500 | 3900 | 4000 |
| XYZ Co | 3000 | 5000 | 7000 | 9000 | 10000 |
By using the formula
ICR = EBIT/Interest
| Company | 2015 | 2016 | 2017 | 2018 | 2019 |
| ABC Co | 2.69 | 2.94 | 3.43 | 3.59 | 3.75 |
| XYZ Co | 3 | 2 | 1.71 | 1.56 | 1.5 |
The results indicate that the ICR of ABC Co. enjoyed growth for the duration, then remained constant for the time in question. On the other hand, the ICR for XYZ Co. is going down just by leaps and bounds; hence, it is an indication of service stability and liquidity.
Interest Coverage Ratio: Importance and Use
These are some of the most common applications for this ratio:
- When it comes to interest on debt pay-outs or defaults, a detailed examination of the interest coverage ratio provides a clearer understanding of a company’s viability.
- It assists lenders in determining a company’s creditworthiness prior to granting credit. Generally speaking, they favor companies with a high ICR.
- This ratio is used by stakeholders, such as investors, employees, and creditors, to assess the profitability of the companies. Consequently, it enables them to make prompt decisions.
- It is useful for assessing a company’s short-term financial health and stability.
However, in order to apply this financial statistic more effectively, people need to learn about its limitations.
Disadvantages of the Interest Coverage Ratio
An interest coverage ratio, like other financial ratios, makes it difficult to predict a company’s long-term financial health.
Apart from that, the following highlights this ratio’s limitations:
- Seasonal factors may distort the lesson because these factors are not taken into consideration. It does not give the real idea of the financial situation of a company.
- The ratio, however, does not reflect how taxes affect the cash flow of the organization.
- Interest coverage becomes the least suitable measure in analyzing the profit or performance of companies from different industries because it diversified widely.
- Some debts may be isolated or excluded by companies when calculating the ratio.
The interest coverage ratio should be used in conjunction with other measures, such as the debt-to-equity ratio, quick ratio, current ratio, cash ratio, etc., to analyze a company’s financial statements. It will make it possible to more effectively mitigate the drawbacks and maximize the advantages of the aforementioned metric.
Additionally, before giving money to a specific business or investing in it, one should consider other things.
The Interest Coverage Ratio: Primary Uses
- A company’s ability to cover its interest costs on outstanding debt is assessed using its internal rate of return (ICR).
- Lenders, creditors, and investors use ICR to assess how risky it is to provide money to the business.
- A decreasing ICR is a sign that a business would eventually be unable to pay its debts. ICR is used to assess a company’s stability.
- A company’s short-term financial health is assessed using its ICR.
- ICR trend analysis provides a clear view of a company’s interest payment stability.
FAQs
Ans- This financial indicator indicates how many times a business may use its profits before interest and taxes (EBIT) to pay interest.
Ans- Interest Coverage Ratio = EBIT ÷ Interest Expense.
Ans- It demonstrates that the company is in a strong position to settle its interest-bearing debts.
Ans- It’s bad, it means the company cannot cover its interest payments from current earnings.
Ans- It is used by analysts, investors, and lenders to evaluate a company’s capacity to repay loans.
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