# Interest Coverage Ratio

Used to determine a company's ability to pay interest on its outstanding debt

## What is Interest Coverage Ratio (ICR)?

The Interest Coverage Ratio (ICR) is a financial ratio that is used to determine the ability of a company to pay the interest on its outstanding debt. The ICR is commonly used by lenders, creditors, and investors to determine the riskiness of lending capital to a company. The interest coverage ratio is also called the “times interest earned” ratio.

### Interest Coverage Ratio Formula

The interest coverage ratio formula is calculated as follows:

Where:

• EBIT is the company’s operating profit (Earnings Before Interest and Taxes)
• Interest expense represents the interest payable on any borrowings such as bonds, loans, lines of credit, etc.

### Interest Coverage Ratio Example

For example, Company A reported total revenues of \$10,000,000 with COGS (costs of goods sold) of \$500,000. In addition, operating expenses in the most recent reporting period were \$120,000 in salaries, \$500,000 in rent, \$200,000 in utilities, and \$100,000 in depreciation. The interest expense for the period is \$3,000,000. The income statement of Company A is provided below:

To determine the interest coverage ratio:

EBIT = Revenue – COGS – Operating Expenses

EBIT = \$10,000,000 – \$500,000 – \$120,000 – \$500,000 – \$200,000 – \$100,000 = \$8,580,000

Therefore:

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

Company A can pay its interest payments 2.86 times with its operating profit.

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### Interpretation of Interest Coverage Ratio

The lower the interest coverage ratio, the greater the company’s debt and the possibility of bankruptcy. Intuitively, a lower ICR 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.

However, a high ICR may also indicate that a company is overlooking opportunities to magnify their earnings through leverage. As a rule of thumb, an interest coverage ratio above 2 is considered the minimum acceptable amount. In some cases, analysts would like to see an ICR above 3. An ICR below 1 indicates that a company is not able to pay off its current interest payment obligations and is therefore in poor financial health.

### Primary Uses of Interest Coverage Ratio

• ICR is used to determine the ability of a company to pay their interest expense on outstanding debt.
• ICR is used by lenders, creditors, and investors to determine the riskiness of lending money to the company.
• ICR is used to determine company stability a declining ICR is an indication that a company may be unable to meet its debt obligations in the future.
• ICR is used to determine the short-term financial health of a company.
• Trend analysis of ICR gives a clear picture of the stability of a company in regards to interest payments.

For example, let us use the concept of interest coverage ratio to compare two companies:

When comparing the ICR’s of both Company A and B over a period of 5 years, we can see that Company A steadily increased its ICR and appears to be more stable, while Company B showed a decreasing ICR and might face liquidity issues in the future.

### Additional Resources

CFI is a global provider of financial analyst training and career advancement for finance professionals, including the Financial Modeling & Valuation Analyst (FMVA)™ certification program. To learn more and expand your career, check out the additional relevant resources below.

• Interest Expense
• Effective Annual Interest Expense
• Cost of Debt
• Debt Schedule

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