The Interest Coverage Ratio (ICR) measures how easily a company can pay interest on its debts using its earnings. Most lenders and investors use this ratio to assess the financial stability of a company and its ability to handle future borrowing. Generally, a higher ICR suggests the company is less risky and more financially secure.
It must be noted that when a company has strong earnings, it means it has a financial buffer to absorb any temporary drops in revenue. This cushion ensures the company can still meet its debt obligations even if its income declines.
Let us take a closer look at the meaning of the interest coverage ratio, how it is calculated, and the different types of coverage ratios.
What is the interest coverage ratio?
The interest coverage ratio is a metric used to measure the number of times a company can pay the interest costs on its debts using its earnings (before deducting interest and taxes). This is why the ratio is also called the ‘times interest earned.’
It only compares the Earnings Before Interest and Taxes (EBIT) with the interest due on a company’s liabilities. The principal component of these debts is not taken into account. A higher interest coverage ratio typically means that a company earns enough (before interest and taxes) to repay the interest on its debts many times over. This is an attractive proposition for investors with a long-term outlook.
Interest coverage ratio formula
The interest coverage ratio is calculated by dividing a company’s operating earnings by its interest expenses. Mathematically, it can be represented as follows:
ICR = EBIT/(Interest expense (net))
Where,
- EBIT (Earnings Before Interest and Taxes) is calculated by subtracting operating expenses from gross profit.
- Interest Expense (net) is the cost of interest after subtracting any interest income.
It is worth mentioning that the EBIT-based ICR provides a balanced view of the company's ability to cover its interest payments. Also, when investors and analysts refer to "interest coverage ratio," they usually refer to this EBIT-based version.
How to calculate the interest coverage ratio?
To find the interest coverage ratio, divide the EBIT by the interest expenses on a company’s debts. This gives us the following formula for the ICR.
Interest coverage ratio = Earnings before interest and taxes ÷ Interest on debt |
For example, say the EBIT of a company is Rs. 100 crore and the interest expenses on its debt amount to Rs. 16 crore. This translates to an interest coverage ratio of 6.25. It essentially means that the company can pay the interest on its liabilities 6.25 times during the financial year using its earnings.
How to interpret interest coverage ratios?
The value of the interest coverage ratio can tell you a great deal about how capable a company is in managing the cost of its debts. Here is how you can interpret the results from calculating the ICR.
Interest coverage ratio value |
What it could indicate |
1 or below |
A low value of the interest coverage ratio indicates that the company is unable to meet the cost of its debt efficiently and may potentially default on its liabilities. |
1.5 to 2 |
An interest coverage ratio in this range means that the company has adequate earnings to cover the cost of its liabilities and debts. |
More than 2 |
A high value of the interest coverage ratio means that the company earns many times more than the cost of its debts, so it can easily meet its financial obligations. |
What is a good interest coverage ratio?
What constitutes a favorable interest coverage ratio varies across industries. For instance, manufacturing and technology sectors exhibit distinct debt obligations. Generally, a minimum interest coverage ratio of two is deemed acceptable, while investors and analysts typically seek ratios of at least three, indicating stable revenue streams.
Conversely, a deficient interest coverage ratio, typically below one, signifies inadequate earnings to meet outstanding debt obligations. Although some companies with debt servicing challenges may persevere, a low or negative interest coverage ratio typically alarms investors, suggesting potential bankruptcy risks.
Interest coverage ratio example
The interest coverage ratio can directly give you some insights into how well a company manages its debts. It can also be useful for assessing financial stability and comparing investment options. For instance, take the case of two companies and their ICR over three years, as shown in the example below.
- |
Year 1 |
Year 2 |
Year 3 |
|
EBIT (Rs. lakh) |
Company A |
10,000 |
15,000 |
20,000 |
Company B |
10,000 |
15,000 |
20,000 |
|
Interest expenses (Rs. lakh) |
Company A |
3,000 |
3,850 |
4,760 |
Company B |
3,500 |
8,100 |
11,500 |
|
ICR |
Company A |
3.33 |
3.90 |
4.20 |
Company B |
2.86 |
1.85 |
1.74 |
|
From the table above, it is evident that for company A, the interest coverage ratio increases year after year, indicating growing financial stability. Company B, on the other hand, shows consistently declining ICR because of its rising cost of debt.
Significance of the interest coverage ratio
The ICR has many uses and benefits. It’s key significance for businesses, investors, and analysts stems from the following advantages.
- It helps understand if a company is financially stable or is likely to default on its debts.
- It allows lenders to assess how creditworthy a company is (a high ICR is preferred).
- Investors can use the ICR, along with other ratios, to evaluate how profitable a company is.
Analysis of interest coverage ratio
A higher interest coverage ratio is generally considered better, but it's important to recognise that the ideal ratio can vary depending on the industry. Here's a breakdown to help you interpret this financial metric:
- Below 1: This indicates the company might struggle to generate enough cash to cover its interest obligations.
- Below 1.5: This suggests the company may have difficulty paying interest on its debt. A low ratio signifies a high debt burden and increased risk of default or bankruptcy. It can also hurt the company's reputation.
- 2.5 to 3: This indicates the company can comfortably service its debt with current earnings. However, it could also reflect a company policy or requirement to maintain a higher ratio.
The acceptable interest coverage ratio varies by industry. For instance, utility companies like electricity or natural gas providers tend to have lower ratios due to their stable sales. In contrast, industries with volatile sales, like technology or manufacturing, often have higher ratios.
A high EBIT (earnings before interest and taxes) doesn't necessarily guarantee a high interest coverage ratio. It's crucial to consider the company's specific financial situation when analyzing this metric.
Types of Interest Coverage Ratios
While the interest coverage ratio is commonly used, you can also use other variations of the ratio to assess how solvent a company is. Some of the different types and variations of this ratio include the following:
- EBITDA interest coverage ratio
Here, the Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA) are used to compute the ratio. It tells you how often a company can service its debt interest using its EBITDA. - Fixed Charge Coverage Ratio (FCCR)
The FCCR measures how well a company’s earnings before interest and taxes can cover its fixed charges like debt repayments, interest costs, and lease expenses. A higher FCCR indicates better solvency. - EBITDA less capex interest coverage ratio
This is a variation of the interest coverage ratio where the company’s capital expenditure is deducted from its EBITDA, and the resulting number is compared with the entity’s debt interest costs. - EBIAT interest coverage ratio
In this variation of the interest coverage ratio, you use the Earnings Before Interest and After Taxes (EBIAT) instead of the EBIT. This measures how well the post-tax earnings cover a company’s debt interest costs.
Enhance your expertise by checking out these related reads:
- What is a current ratio
- What is the cash ratio
- What is a Treynor Ratio
- What is the quick ratio
- What is an expense ratio
- What are mutual fund ratios
Primary uses of interest coverage ratio
The interest coverage ratio shows how well a company can pay the interest on its debts using its earnings. Lenders, creditors, and investors use this ratio to assess the risk of lending money to a company and evaluate its short-term financial health and overall stability.
A higher ICR indicates that a company comfortably meets its interest obligations. It suggests financial stability and lower risk for lenders. On the other hand, a declining ICR signals potential liquidity issues. It shows that the company could struggle to meet its debt payments in the future.
For more clarity, let’s study a hypothetical example where two companies A and B are compared:
Year |
Company A (EBIT) |
Company A (Interest) |
Company A (ICR) |
Company A (EBIT) |
Company A (Interest) |
Company A (ICR) |
2013 |
Rs. 9,000 |
Rs. 3,350 |
2.69 |
Rs. 9,000 |
Rs. 3,000 |
3.00 |
2014 |
Rs. 10,000 |
Rs. 3,400 |
2.94 |
Rs. 10,000 |
Rs. 5,000 |
2.00 |
2015 |
Rs. 12,000 |
Rs. 3,500 |
3.43 |
Rs. 12,000 |
Rs. 7,000 |
1.71 |
2016 |
Rs. 14,000 |
Rs. 3,900 |
3.59 |
Rs. 14,000 |
Rs. 9,000 |
1.56 |
2017 |
Rs. 15,000 |
Rs.4,000 |
3.75 |
Rs. 15,000 |
Rs. 10,000 |
1.50 |
Upon studying the above table, we can observe that:
- For Company A
There is a steady increase in its ICR over the five-year period, which rises from 2.69 in 2013 to 3.75 in 2017. This upward trend indicates that Company A has been improving its ability to cover interest expenses. Also, it shows growing financial stability and reduced risk for lenders and investors.
- For Company B
This company shows a declining ICR, which dropped from 3.00 in 2013 to 1.50 in 2017. This downward trend suggests that Company B is becoming less capable of meeting its interest obligations. Also, it signals emerging liquidity problems and increased risk for stakeholders.
Limitations of the interest coverage ratio
The interest coverage ratio also has some limitations. It does not factor in the impact of taxes on a company’s earnings. It also does not account for seasonal changes and variations in a company’s income. To overcome these limitations, you can use a variation of the interest coverage ratio.
Key takeaways
- The interest coverage ratio assesses a company's ability to meet its interest obligations on outstanding debt.
- It's calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense over a specific period.
- Variations of the formula may use EBITDA or EBIAT instead of EBIT.
- While a higher coverage ratio is typically preferable, the ideal ratio can differ across industries.
Conclusion
The interest coverage ratio is one of the key financial metrics to analyse before making a long-term investment in any company. However, this ratio alone does not give you the whole picture. You must also evaluate other key financial ratios like the debt-to-equity (D/E) ratio, current ratio, and quick ratio. This can offer a more comprehensive idea of how a company manages its debts and liabilities.
