What is Interest Coverage Ratio – Meaning, Formula and Example
What is Interest Coverage Ratio?
The interest coverage ratio (often abbreviated as ICR) is one of the many solvency checks used by a company to determine its default risk. A company uses this financial measure to assess how easily it can pay off the interest expenses on its outstanding liabilities. An important point to note here is that this liquidity ratio is not an indicator of a company’s ability to pay off the principal component of its debt obligations. It is also a measure of a company’s profitability and creditworthiness.
Why is the Interest Coverage Ratio Important?
The interest coverage ratio tells a company how easily it can meet its outstanding debt obligations. It also tells a company whether it has sufficient headroom to borrow more from the market to meet its operational costs or to explore new growth opportunities.
2. Helps Evaluate a Company’s Financial Solvency
Interest coverage ratio is an important indicator of a company’s financial solvency. A relatively high interest coverage ratio is an indicator of how well a company can manage its debts and grow in the long term.
3. Helps Investors Evaluating the Growth Potential of a Company
This ratio can tell interested investors whether a company can pay off its interest dues on time, without compromising on its profitability, expansion plans, and operational stability. A company is seen as a high-risk investment if this ratio is too low.
4. To Determine a Company’s Creditworthiness
Creditors often use this ratio to analyse a company’s ability to repay the interest on its outstanding debt. If a company’s interest coverage ratio is too low, creditors may view it as a red flag as this indicates a higher probability for the company to default.
5. To Determine a Company’s Overall Financial Health
Interest coverage ratio tells investors, creditors, and stakeholders how easily it can pay off its debt on a long-term basis. This can tell them whether the company will continue to remain stable in the long run and grow steadily while successfully avoiding debt traps.
How Is the Interest Coverage Ratio Calculated?
Interest Coverage Ratio Formula
Interest coverage ratio follows a simple formula which comprises two parts: a company’s earnings before interest and tax (EBIT) in the numerator and the company’s interest expense on debt for the period in the denominator:
Interest Coverage Ratio (ICR) = Earnings before Interest and Taxes (EBIT) ÷ Interest expenses
Understanding Interest Coverage Ratio Calculation with an Example
Let us understand this concept better with an example. Let’s consider EBIT and interest expenses for two companies, namely A and B, over a period of 3 years – 2019, 2020, and 2021.
Comparing EBIT for the two Companies:
| Company | 2019 (in ₹ Crore) | 2020 (in ₹ Crore) | 2021 (in ₹ Crore) |
| A | 5,000 | 5,500 | 6,000 |
| B | 7,000 | 7,700 | 8,500 |
Comparing Interest Expenses for the two Companies:
| Company | 2019 (in ₹ Crore) | 2020 (in ₹ Crore) | 2021 (in ₹ Crore) |
| A | 1,000 | 1,500 | 2,000 |
| B | 3,500 | 3,200 | 3,000 |
Now, let us compare the interest coverage ratio for the two companies over the 3 years in question:
Interest Coverage Ratio Comparison
| Company | 2019 | 2020 | 2021 |
| A | 5 | 3.67 | 3 |
| B | 2 | 2.41 | 2.83 |
Comparing the interest coverage ratio for the two companies, we can conclude that the ratio for company A has been falling over the period in question, even though it is still quite stable and displays an ability to repay its interest dues on time.
Company B, in comparison with Company A, has a lower interest coverage ratio for all the 3 years in question. However, since the ratio is constantly improving, it could send a positive signal to investors, creditors, and other stakeholders that if the trend continues, company B could eventually increase its profitability further and be in a better position to meet its interest repayment obligations.
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What are the Variations of Interest Coverage Ratios?
Here are some popular variations that companies use to get a more accurate picture of their solvency and debt repayment capabilities:
Here are some popular variations that companies use to get a more accurate picture of their solvency and debt repayment capabilities:
1. Using EBITDA Instead of EBIT in the Numerator
Some companies, investors, and creditors prefer to look at earnings before interest, taxes, depreciation and amortisation (EBITDA) instead of simply EBIT. As amortisation and depreciation is excluded from the numerator, even though the denominator remains unchanged, the formula for ICR using EBITDA may often return a higher number than the conventional formula using EBIT.
This variation is often preferred by companies that have significant investment in tangible and intangible assets and want to reduce the impact of depreciation and amortisation costs from their earnings.
2. Using EBIAT Instead of EBIT in the Numerator
Another popular variation is earnings before interest after taxes instead of earnings before interest and taxes in the numerator of the interest coverage ratio formula. Some experts believe that this variation could give a more accurate picture of a company’s ability to pay off interest on its outstanding debt, since taxes also take a chunk away from the company’s total earnings.
Uses of Interest Coverage Ratio
1. Creditworthiness
It is used by lenders to determine the risk of lending money to a company.
2. Financial Stability
It is an important measure of a company’s solvency that is its ability to service its debts. This proves that the company has sufficient headroom to borrow money to follow its growth trajectory, while remaining financially and operationally stable.
3. Short-term Financial Health
This ratio gives an accurate measure of a company’s ability to repay its short-term debts – which can also be interpreted as its ability to pay its upcoming bills and take care of other fixed expenses, while remaining financially secure.
4. Settle Interest Charges
ICR is a measure of a company’s ability to repay the interest charges on its debts, such as bonds, lines of credit, etc. If the ICR for a company is sufficiently high, it shows that the company is generating enough cash flow to meet its interest obligations and has a lower probability of defaulting.
How to Interpret Interest Coverage Ratio?
Let us look at the interest coverage ratio interpretation, based on certain common scenarios:
1. If Interest Coverage Ratio for a Company is Equal to 1
Lenders consider companies whose interest coverage ratio equals 1 as relatively risky prospects. This is because such companies are not generating sufficient cash flow. At any point of time, they can either pay the interest amount on an outstanding debt or the principal amount but not both.
2. If the Interest Coverage Ratio is Less than 1
Companies in this category are at very high risk as they are not generating sufficient cash or profits to pay the interest dues on their loans. This implies that companies with interest coverage ratios below 1 may not remain financially stable for long and could even go out of business. As a result, lenders may not want to extend credit to these firms since these companies have a high probability of defaulting on their loans.
3. If Interest Coverage Ratio is Greater than 1
A company whose interest coverage ratio exceeds 1 generally has sufficient resources to pay the interest component on their loan. As a result, lenders and stakeholders usually consider these companies to be relatively safe. However, a higher interest coverage ratio is generally preferred since it is a strong indicator of its financial health.
4. If Interest Coverage Ratio is Greater than 2
Usually, lenders and stakeholders consider 2 as a good interest coverage ratio. This is because such companies have enough funds to settle the interest dues, pay for their day-to-day expenses and fixed costs, and still have enough funds to explore new markets and growth opportunities.
What Is the Ideal Interest Coverage Ratio?
While the ideal interest coverage ratio for a company would depend on a number of factors, such as its long-term financial goals, growth prospects, its size, and its sector among other things, a ratio of at least 2:1 i.e. 2 is considered to be good.
For instance, utility service industries, such as natural gas and electricity, usually have a low-interest coverage ratio even though their revenue and sales are typically high. Moreover, these companies do not suffer from seasonality, meaning their sales tend to remain stable over a relatively long period of time. For such industries, even a ratio below 2 or 1.5 could be seen as ‘good’.
However, the scenario is different for technology and manufacturing industries. The ideal interest coverage ratio for these industries is quite high. So, lenders may consider a ratio higher than 2 to be ‘ideal’ or ‘optimal’ for these industries.
What Are the Benefits of Using an Interest Coverage Ratio?
1. Simple Calculation:
It is quite easy to calculate. It also doesn’t require a lot of data or an in-depth knowledge of finance or accountancy. Even relatively new and inexperienced investors can use it to evaluate the solvency of a company.
2. Evaluating Ability to Borrow More:
With the help of interest coverage ratio, a company can assess their debt repayment capabilities, based on their present earnings. If the ratio indicates inability to pay off interest on the company’s loan, it can decide to hold off on further borrowing or even pay off the loan quicker to reduce its debt burden.
3. Helps Evaluate Credit Risk:
Lenders and prospective investors can use this ratio to check the credit risk of a company and get a sense of the company’s short-term financial health and long-term financial stability. An investor can use this as a parameter to evaluate different stocks.
4. Simple Interpretation:
Interest coverage ratio is easy to interpret even for those without much financial knowledge or understanding.
5. Forecasting Future Performance:
An investor can analyse the interest coverage ratio trend over a period of time to forecast the financial health and performance of a company over time. The trend in the ratio can help them identify growth opportunities or identify potential risks.
What are the Limitations of Interest Coverage Ratio?
1. It May Not Provide an Accurate Picture of a Company’s Financial Stability
A firm’s earnings can vary seasonally. However, this ratio does not reflect the impact of seasonality on a company’s performance. It fails to paint an accurate image of a firm’s solvency. It cannot be used in isolation to identify a firm’s profitability or ability to service debts.
2. It is Based on Historical Data
The ratio can only be used to forecast a company’s future financial performance. However, since it is based on historical data, it can only provide a prediction of a company’s future performance, while the actual performance could be quite different.
3. A ‘Single’ Ideal Interest Coverage Ratio not Available
Although the ideal ratio is often considered to be 2 and above, the ‘ideal’ ratio could vary from industry to industry. It could also differ based on the size of a company, growth prospects, and other factors.
Final Word
The interest coverage ratio is a strong measure of a company’s solvency and financial health. By tracking it, a company can ensure that it isn’t overleveraged or is not overborrowing when compared to its financial performance. It can also be used by investors and lenders to estimate the creditworthiness and potential default risks of a company.
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FAQs
Interest coverage ratio can be improved in two ways. First, one can opt to increase the firm’s earnings before interests for a better interest coverage ratio. The second way is by cutting down expenses of the firm.
The interest service coverage ratio focuses on the interest expenses of a firm. However, a debt service coverage ratio analyses a firm’s capacity to repay its debt.
No, the interest coverage ratio is a solvency ratio that checks the financial standing of a firm.
A loan in which the borrower has failed to repay the interest or principal for 90 days is considered a non-performing asset (NPA).
An interest coverage ratio of 4 implies that a firm can pay its outstanding interest four times in an accounting year.
Typically to use the interest coverage ratio calculator, you will have to enter the earnings before interest and taxes for the company you want to find the ratio for and its interest expenses. It will use the following formula to give you the ratio:
Interest coverage ratio = EBIT/Interest Expenses
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
