Interest Coverage Ratio: Calculation and Example

# Interest Coverage Ratio: Calculation and Example

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Jaya Sharma
Senior Executive Content
Updated on Dec 5, 2023 22:41 IST

Interest Coverage Ratio determines the ability of a company to fulfill its interest obligations. It is a ratio that compares company earnings (before interest and taxes) to interest expenses. Essentially, it shows how many times a company can pay its interest charges using its operating profit. A higher ICR suggests a company is in a good financial position to handle its debt, while a lower ICR could signal potential financial difficulties.

Interest Coverage Ratio or ICR refers to a financial metric that assesses a company’s ability to manage its interest expenses. It’s a measure of financial stability, indicating how easily any company can pay interest on its outstanding debt. ICR is a crucial part of financial analysis, providing insights into a company’s operational efficiency and financial leverage.

## Interest Coverage Ratio in Simpler Terms

Think of the Interest Coverage Ratio (ICR) like a person’s ability to pay their monthly bills.

Just as a person needs to earn enough money to cover their bills (like rent, utilities, and groceries), a company needs to earn enough to cover its interest expenses on its debt. If a person earns significantly more than their monthly bills, they are in a comfortable financial position.

Similarly, higher ICR means a company can easily cover its interest payments, indicating financial stability. Just as you would have analyzed a person’s income and expenses to understand their financial health, analysts use the ICR to understand a company’s financial health and efficiency.

### Importance of ICR

Following points make the use of ICR important:

• The Interest Coverage Ratio (ICR) is crucial for investors, creditors, and financial analysts.
• It offers insights into a company’s financial health.
• It shows a company’s ability to meet financial obligations.
• A higher ICR is generally favorable.
• It indicates that a company can cover its interest payments with earnings.
• The ICR provides a brief of a company’s short-term financial health.
• A low ICR may signal financial distress or bankruptcy risk.

### How to Calculate Interest Coverage Ratio?

Interest Coverage Ratio is calculated by dividing company’s EBIT (Earnings Before Interest and Taxes by its interest expenses for the same period.

The formula is: ICR = EBIT / Interest Expenses.

This ratio shows how many times a company can cover its interest charges with its operating profit.

#### Example 1

If a company has an EBIT of 1 million rupees and interest expenses of rupees 2,00,000, its ICR would be 5. This means it can cover its interest expenses five times over with its operating profit.”

#### Example 2

Let us say Company A has an EBIT of \$2 million and interest expenses of \$500,000 for the same period. To calculate the ICR, we divide the EBIT by the interest expenses: \$2,000,000 / \$500,000 = 4. This means Company A can cover its interest expenses four times over with its operating profit.

#### Example 3

Consider Company B with an EBIT of \$750,000 and interest expenses of \$150,000. The ICR would be: \$750,000 / \$150,000 = 5. This means Company B can cover its interest expenses five times over with its operating profit.

#### Example 4

Suppose Company C has an EBIT of \$600,000 and interest expenses of \$200,000. The ICR would be: \$600,000 / \$200,000 = 3. This means Company C can cover its interest expenses three times over with its operating profit.

#### Example 5

Let us take Company D with an EBIT of \$1.2 million and interest expenses of \$300,000. The ICR would be: \$1,200,000 / \$300,000 = 4. This means Company D can cover its interest expenses four times over with its operating profit.

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## Interpretation of the Interest Coverage Ratio (ICR)

Interest Coverage Ratio is a measure of a company’s financial strength and stability. It’s a ratio that shows how well a company can cover all its interest expenses with its operating profit. The interpretation of this ratio is largely dependent on its value.

• When the ICR is high, it suggests that the company has a strong ability to pay the interest on its debt. This is because a high ICR indicates that the company’s earnings (before interest and taxes) are significantly greater than its interest expenses. It is seen as a positive sign by investors and creditors, as it suggests that the company is financially stable and has a lower risk of defaulting on its debt.

For instance, if a company has an ICR of 5, it means that it can cover its interest expenses five times over with its operating profit.

• A lower ICR may be a warning sign of financial distress. If the ICR is less than 1, it means that the company’s earnings are not sufficient to cover its interest expenses. This could indicate that the company is struggling to generate sufficient revenue to meet its financial obligations. In such a case, the company may need to borrow more money to cover its interest expenses, which could lead to an increase in its debt levels and potentially lead to a vicious cycle of increasing debt and interest expenses.

For example, if a company has an ICR of 0.5, it means that it can only cover half of its interest expenses with its operating profit. This could lead to liquidity problems, as the company may not have enough cash on hand to meet its short-term obligations, including interest payments.

## FAQs

What is a good interest coverage ratio?

A good ICR can vary by industry, however, a ratio of 1.5 or above is acceptable. A ratio under 1 could indicate that the company is having difficulty meeting its interest obligations.

Can the ICR be negative?

Yes, the ICR can be negative if EBIT is negative, indicating that the company is not profitable.

What is the difference between the ICR and the Debt Service Coverage Ratio?

While the ICR only considers interest expenses, the DSCR takes into account both principal and interest payments, providing a more comprehensive view of the ability of a company to service its debt.

Why is the ICR important to investors?

The ICR is important to investors as it provides insights into a financial stability and its ability to meet its debt obligations. A higher ICR may indicate a lower risk investment.

How does the ICR affect the credit rating of a company?

Credit rating agencies often use the ICR as part of their assessment. A higher ICR can contribute to a better credit rating, as it indicates lower financial risk.

What factors can influence the ICR?

Factors that can influence the ICR include changes in a company's profitability, debt levels, and interest rates.