What Is Interest Coverage? How To Calculate It And What It Means

The ICR is a financial ratio used to determine how well a company can pay its outstanding debts. The Interest Coverage Ratio, or ICR, is a financial ratio used to determine how well a company can pay its outstanding debts. Financial ratios use numerical values from a company’s financial statements. These help in offering meaningful insight into a company and its performance. The interest coverage ratio is not designed to account for variations in interest costs. When a company’s debt structure has different interest rates, it might render the ratio less accurate.

• A high ratio indicates there are enough profits available to service the debt.
• In other words, the company will need to use liquidate its assets to repay its loans.
• The interest coverage ratio is one of the most important financial ratios you can use to reduce risk.
• Even though a higher interest coverage ratio is desirable, the ideal ratio tends to vary from one industry to another.
• ICR is best used in combination with other metrics like quick ratio, debt-to-equity ratio, current ratio, etc.
• It demonstrates the number of times a company can pay its interest charges using its operating income.

No metric can be used in isolation to figure out the financial health of a company as they all have their pitfalls. The ICR is also known as the debt service ratio or debt service coverage ratio. It may be calculated as either EBIT or EBITDA divided by the total interest expense of the company. The interest coverage ratio (ICR) indicates how well a company can service its long-term loans. The ICR is calculated by dividing net profit (before deducting the interest) by the total interest expenses.

Interest Coverage Ratio: Understanding Its Importance in Financial Analysis

The lower the interest coverage ratio, the greater the company’s debt and the possibility of bankruptcy. Intuitively, a lower ratio indicates that less operating profits are available to meet interest payments and that the company is more vulnerable to volatile interest rates. Therefore, a higher interest coverage ratio indicates stronger financial health – the company is more capable of meeting interest obligations. It sheds light on how far a company’s earnings can decline before the company begins defaulting on its bond payments.

• Both measurements should be taken for the same set period of time, such as the trailing twelve months (TTM).
• Interest coverage ratio is one of the many metrics that are used for analysing a company’s financial health.
• These ratios can help stakeholders assess a company’s ability to meet its financial obligations and manage its debt.

Also called the “times interest earned ratio,” it is used in order to evaluate the risk in investing capital in that company–and how close that company is to debt insolvency. To incorporate these non-typical debt sources into the calculation, sum up the present value of these obligations and add it to the company’s existing total debt and interest expense. The interest coverage ratio can then be calculated using the new adjusted values.

What Is the Interest Coverage Ratio?

There are other financial obligations that may not be classified as debt in the company’s financial statements but are essentially fixed commitments that the company is required to pay. These include preferred dividends, capital lease obligations, and post-retirement health care liabilities, among others. On the other hand, a low interest coverage ratio indicates a firm’s struggle to pay off its interest expenses. A ratio lesser than 1 specifically demonstrates that the company is unable to meet its interest obligations from its current earnings, signalling that it is financially distressed.

Interest Coverage Ratio

The interest coverage ratio is computed by dividing 1) a corporation’s annual income before interest and income tax expenses, by 2) its annual interest expense. He has spent the decade living in Latin America, doing the boots-on-the ground research for investors interested in markets such as Mexico, Colombia, and Chile. He also specializes in high-quality compounders and growth stocks at reasonable prices in the US and other developed markets.

EBITDA

The formula of interest coverage ratio can be expressed by dividing a company’s EBIT by its interest expense. There are mainly two ways by which you can increase the ICR of your company. The first way is by increasing the earnings before interest and tax (EBIT) which can be achieved once revenue is increased. A high ICR indicates that a company has a healthy financial position and is able to easily meet its interest obligations. However, some analysts prefer to use the EBITDA to Interest Coverage Ratio instead. The interest coverage ratio is a useful tool and can be used to great effect.

By analysing ICR, lenders can assess the borrowing company’s credibility and its capability to service the debt. Many banks and lenders generally have ICR as part of their due diligence for loans. Every investor or stakeholder should thus utilize this ratio, not in isolation, but along with other financial indicators cash receipts journal example and ratios to make informed decisions. The second component, known as ‘interest expense’, represents the total amount of interest that has been charged to the company for its borrowings during a particular period. This value can typically be found in the financing section of the company’s income statement.

The EBITDA-to-interest coverage ratio is also known simply as as EBITDA coverage. The main difference between EBITDA coverage and the interest coverage ratio, is that the latter uses earnings before income and taxes (EBIT), rather than the more encompassing EBITDA. A company with an ICR of around 8, indicates that it can generate eight times the earnings (EBIT) compared to its debt interest. This might appear to have a more favorable financial outlook than a company with an ICR of only 1. An interest coverage ratio of 1.5 could be seen as the minimum acceptable threshold, but analysts and investors might prefer a ratio of two or higher. Companies with a history of fluctuating revenues might not consider ICR below 3 good.

For instance, if the interest coverage ratio is 4, it means the corporation has enough operating profits to pay its interest expenses four times over. The interest coverage ratio is an indispensable tool used by businesses, investors, and creditors alike to evaluate an entity’s ability to cover its interest expense on outstanding debt. As such, it offers a measure of a company’s sustainability and financial stability.

In summary, a strong interest coverage ratio can provide the financial stability and flexibility needed for a company to effectively pursue and implement sustainable practices and CSR initiatives. By demonstrating a low risk of default on interest payments, companies can attract investors who are not just seeking immediate returns, but also value sustainability and CSR. Each of these can be valuable, but they reveal different aspects of financial health. For instance, a company could have a high interest coverage ratio due to strong profits, but also have an alarming debt to equity ratio due to its heavy reliance on borrowed money. On the other hand, the debt to equity ratio is a measure of a company’s leverage, representing the proportion of a company’s financing that comes from creditors (debt) compared to shareholders (equity). A high debt to equity ratio may suggest that a company is aggressive in financing its operations with debt, which can be risky if they’re unable to manage their debt levels effectively.