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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:

 

Interest Coverage Ratio Formula

 

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:

 

Income Statement

 

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.

 

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:

 

Interest Coverage Ratio - Example 1

Interest Coverage Ratio - Example 2

 

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

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