When it comes to risk management and reduction, the interest coverage ratio is one of the most important financial ratios you will learn.
An interest coverage ratio is a powerful tool in each of these circumstances.
What is Interest Coverage Ratio (ICR)?
In simple words, the interest coverage is a metric that enables to determine how efficiently a firm can pay off its share of interest expenses on debt.
This ratio is also known as ‘times interest earned’.
It must be noted that this particular ratio is not concerned with the repayment of the principal debt amount.
The ICR is entirely about a firm’s ability to settle interest on its debt.
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.
Another variation of the formula is using earnings before interest, taxes, depreciation and amortization (EBITDA) as the numerator:
Interest Coverage Ratio = EBITDA / Interest Expense
Calculating the Interest Coverage Ratio
This ratio is calculated by dividing earnings before interest and taxes (EBIT) by the total amount of interest expense on all of the company’s outstanding debts.
A company’s debt can include lines of credit, loans, and bonds.
You can use this formula to calculate the ratio for any interest period including monthly or annually.
ABC Company earnings $5,000,000 before interest and taxes in its most recent reporting month. Its interest expense for that month is $2,500,000. Therefore, the company’s interest coverage is calculated as:
$5,000,000 EBIT ÷ $2,500,000 Interest expense
The ratio indicates that ABC’s earnings should be sufficient to enable it to pay the interest expense.
What is a good interest coverage ratio?
An interest coverage ratio above 2 is acceptable and an ICR of less than 1.5 may be considered questionable. The lower the ratio, the more the company is burdened with interest expenses.
Importance of ICR
This is an important figure not only for creditors, but also for shareholders and investors alike.
Creditors want to know a company will be able to pay back its debt.
If it has trouble doing so, there’s less of a likelihood that future creditors will want to extend it any credit.
Similarly, both shareholders and investors can also use this ratio to make decisions about their investments.
A company that can’t pay back its debt means it will not grow. Most investors may not want to put their money into a company that isn’t financially sound.
Deterioration of Interest Coverage
The ratio generally deteriorates in a case when the debt burden is rising for the company, with not much growth in the earnings.
The increased debt burden results in higher interest cost and thus reflects through lower interest coverage ratio.
If you notice a trend of declining interest coverage in your financials, you must indeed be on a lookout for reasons.
This might be due to bad financial management or rising interest rates in the economy. In such a scenario, you must make efforts to optimize your business loans.
Limitations of ICR
Like other financial ratios, it isn’t easy to forecast a company’s long-term financial standing with an interest coverage ratio.
Other than that, these following points emphasise on the limitations of this ratio –
- It does not weigh in seasonal factors which are capable of distorting the ratio. As a result, it does not offer an accurate image of a firm’s financial standing.
- This ratio does not factor in the impact of Tax Expense on the cash flow of an organization.
- Since the interest coverage for companies belonging to different industries is highly variable, it is not the best way to compare their performances or profitability.
Overall, coverage ratios are popular measures to understand whether a company is in a good position to pay off its financial liabilities or not.
If these ratios are greater than 2 then the company is earning more profit than the liabilities but if they are below 1 then the company is not financially sound.
An investor should always investigate these ratios before making an investment decision so that he doesn’t invest in a company that might not be in a position to pay its liabilities because that investment would make investor losses in the long run, if not immediately.