What is Interest Coverage Ratio (ICR)?
The Interest Coverage Ratio (ICR) is a debt or another financial solvency ratio that is used to resolve how well a company can pay the interest on its outstanding debts on time.
ICR is equal to earnings before interest and taxes (EBIT) for a given time period, frequently one year, divided by interest expenses for the same time period.
The interest coverage ratio is sometimes also known as the “times interest earned” ratio.
Distinct from the debt service coverage ratio this ratio really has nothing to do with being able to make principle payments on the debt itself.
Instead, it calculates the firm’s ability to afford the interest on the debt or future borrowing.
The ICR is commonly used by lenders, creditors, and investors to determine the riskiness of lending capital to a company.
For example, an investor is mainly concerned about seeing his investment in the company increase in value. Most of this consent can be based on the profits and operational efficiencies.
So, many investors desire to see their company can able to pay its bills on time without having to sacrifice its operations and profits.
Advantage of Interest Coverage Ratio (ICR)
- It is used to see how healthy a firm can repay the interest on outstanding debt.
- Simply, it’s also called the times-interest-earned ratio.
- This ratio is used by creditors and approaching lenders to assess the risk of lending capital to a company.
- A higher coverage ratio is better for a company.
- It determines a company’s riskiness relative to its current debt or for future borrowing.
- The creditors use this formula to calculate the risk involved in lending.
- It is used to identify whether a company is able to support additional debt.
- This ratio is used to conclude the short-term financial healthiness of a company.
Disadvantage of Interest Coverage Ratio (ICR)
- It is a highly variable nature.
- The companies may choose to isolate or exclude certain types of debt in their interest coverage ratio calculations.
- The ideal ratio may vary from industry-to-industry so investors sometimes confused in the decision about investment.
- Greater fluctuation in business is also deviating the investors.
Formula of Interest Coverage Ratio (ICR)
The interest coverage ratio formula is calculated by dividing the EBIT, or operating earnings before interest and taxes by the interest expense.
Here is what the interest coverage ratio calculated as follows:
- EBIT is the company’s operating profit (Earnings Before Interest and Taxes)
- Interest Expenses represents the interest payable on any borrowings such as bonds, loans, lines of credit, etc.
The reason behind using EBIT in place of net income at the time of calculation is because we want a true sign of how much the company can afford to pay in interest.
If net income is employed within the calculation can be screwed because interest expense would be counted twice and tax expense may change supported the interest being deducted.
To sort out this trouble, we just use the earnings or revenues before interest and taxes are paid.
Example of Interest Coverage Ratio (ICR)
For example, Company XYZ reported total revenues of $10,00,000 with COGS (costs of goods sold) of $4,00,000.
Operating expenses of XYZ company recently reported as $1,20,000 in salaries, $3,00,000 in rent, $1,00,000 in utilities, and $30,000 in depreciation.
The interest expense for the period is $15,000 and $5,000 for taxes.
The income statement of Company XYZ is provided below:Interest Coverage Ratio (ICR) Example
|Income Statement for Company XYZ|
|Costs of gods sold||4,00,000|
|Operating Profit ( EBIT)||50,000|
|Earinings Before Taxes (EBT)||35,000|
Therefore, Applying the above formula, we get;
As you can see, XYZ has a ratio of 3.33. This means that XYZ has makes 3.33 times more earnings than its current interest payments.
It can well afford to pay the interest on her current debt along with its principal payments.
This is a good sign because it shows its company risk is low and her operations are producing enough cash to pay her bills.
Interpretation and Analysis of ICR
Analyzing a coverage ratio may be tricky because it depends largely on what quantity risky the creditor or investor is willing to require.
Depending on the specified risk limits, a bank could be better-off with variety than another.
of this measurement don’t change, however, If the computation is a smaller amount than 1, it means the firm isn’t making enough money to pay its interest payments.
Forget to repay the principal payments on the debt. A company with a calculation but 1 can’t even pay the interest on its debt. This kind of company is beyond risky and possibly would never get bank financing.
Due to lower interest coverage ratio the greater chance of the company’s debt and raised the possibility of bankruptcy.
Naturally, a lower ratio indicates that less operating profits are available to satisfy interest payments which the firm is more susceptible to volatile interest rates.
If the coverage equation equals 1, it means the firm makes simply enough money to pay its interest.
This situation isn’t far better than the last one because the firm still can’t afford to form the principal payments.
It can only cover the interest on the present debt when it comes due.
If the coverage measurement is above 1, it implies that the firm is making quite enough money to pay its interest obligations with some extra earnings left over to form the principal payments.
Most creditors seek for coverage to be a minimum of 1.5 before they’re going to make any loans.
In other words, banks want to make certain an organization makes a minimum of 1.5 times the quantity of their current interest payments.
Going back to our example above, XYZ’s percentage is 3.33. it’s making enough money from her current operations to pay her current interest rates 3.33 times over.
This company is extremely liquid and shouldn’t have a problem getting a loan to expand.