What is Interest Coverage Ratio (ICR)?
The Interest Coverage Ratio (ICR) is a financial ratio that is used to determine how well a company can pay the interest on its outstanding debts. 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:
- 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
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 interest coverage 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.
However, a high interest coverage ratio may also indicate that a company is overlooking opportunities to magnify their earnings through leverage. As a rule of thumb, an ICR above 2 would be barely acceptable for companies with consistent revenues and cash flows. In some cases, analysts would like to see an ICR above 3. An ICR lower than 1 implies poor financial health, as it shows that the company cannot pay off its short-term interest obligations.
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.
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