The Interest Coverage Statistic (ICR) is a financial ratio that is used to determine a company’s ability to pay interest on existing debts. The ICR is often used by lenders, creditors, and investors to measure the risk of financing money to a company. The interest coverage ratio is also known as the “times interest earned” ratio.
Interpretation of the Interest Coverage Ratio
The lower the interest coverage ratio, the greater the company’s debt and risk of bankruptcy. A smaller ratio implies that there are fewer operational earnings available to meet interest payments, exposing the corporation to interest rate swings.
As a result, a higher interest coverage ratio indicates that the company is in better financial condition and can meet its interest payments.
A high ratio, on the other hand, may suggest that a company is ignoring opportunities to leverage its profits. As a general rule, an ICR greater than 2 is barely acceptable for organisations with consistent sales and cash flows. In some cases, analysts would like to see an ICR greater than 3.
An ICR less than one implies that the company is in poor financial health since it is unable to pay off its short-term interest payments.
The Importance of the Interest Coverage Ratio
The ability of any corporation to stay afloat in terms of interest payments is a big and ongoing concern. When a company is unable to satisfy its obligations, it may be forced to borrow more or use its cash reserve, which would be better spent on capital assets or in an emergency.
While a single interest coverage ratio might reveal a lot about a company’s current financial status, examining interest coverage ratios across time can sometimes reveal a lot more about a company’s position and trajectory.
Looking at a company’s quarterly interest coverage ratios over the last five years, for example, can inform investors whether the ratio is improving, declining, or stable, and can give you a decent picture of how strong its short-term finances are.
Furthermore, the desirability of any particular level of this ratio is somewhat subjective. Some banks or bond purchasers may be ready to accept a lower ratio in exchange for a higher interest rate on the company’s debt.
Different Types of Interest Coverage Ratios
Before delving into company ratios, it’s critical to understand two common variants of the interest coverage ratio. These variations are caused by changes in EBIT.
When calculating the interest coverage ratio, one option is to use earnings before interest, taxes, depreciation, and amortization (EBITDA) rather than EBIT. Because this difference does not include depreciation and amortization, the numerator in EBITDA estimations is frequently greater than the numerator in EBIT calculations.
Because interest expenditure is the same in both cases, EBITDA calculations yield a higher interest coverage ratio than EBIT calculations.
In alternative formulation, the interest coverage ratio is calculated using earnings before interest and taxes (EBIAT) rather than profits before interest and taxes (EBIT).
This removes tax costs from the numerator, resulting in a more realistic representation of a company’s ability to pay interest expenses. Because taxes are an important financial issue to consider, EBIAT can be used instead of EBIT to calculate interest coverage ratios to gain a better picture of a company’s ability to cover its interest expenses.
The Limitations of the Interest Coverage Ratio
The interest coverage ratio, like any other statistic used to evaluate a company’s efficiency, has a number of limitations that any investor should be aware of before using it.
To begin, while comparing organisations across industries, and even within the same business, it is critical to remember that interest coverage varies substantially. A two-to-one interest coverage ratio is frequently considered appropriate for established firms in particular industries, such as a utility company.
Because of government controls, a well-established utility is more likely to have steady output and revenue, therefore it may be able to fulfil its interest payments dependably even with a low interest coverage ratio. Manufacturing, for example, has a minimum acceptable interest coverage ratio of three or greater.
These companies are more prone to face business swings. Automobile sales, for example, plunged during the 2008 crisis, putting the auto manufacturing industry in peril.
A workers’ strike is another example of an unforeseeable event that could reduce interest coverage ratios. Because these industries are more vulnerable to these fluctuations, they must rely on a greater ability to cover interest to compensate for periods of low revenue.
Because industries vary so considerably, a company’s ratio should be compared to others in the same industry—ideally, those with similar corporate structures and sales figures.
Furthermore, while all debt should be considered when calculating the interest coverage ratio, businesses may choose to isolate or exclude specific types of debt from their calculations. As a result, it’s vital to verify that a company’s self-published interest coverage ratio includes all obligations.
What Is the Interest Coverage Ratio, and What Does It Indicate?
The interest coverage ratio measures a company’s ability to handle its debt. It is one of various debt ratios that can be used to analyse the financial health of a company.
The term “coverage” refers to the length of time (often a number of fiscal years) that interest payments can be made with the company’s current earnings. In layman’s words, it demonstrates how many times the company’s earnings can be used to meet its obligations.
What formula is used to calculate the Interest Coverage Ratio?
The ratio is calculated by dividing EBIT (or a variant thereof) by interest on debt expenses (the cost of borrowed funds) over a set period of time, usually a year.
What Is a Good Interest Coverage Ratio?
A ratio larger than one indicates that a company can service its debts with its earnings or has proved the ability to maintain constant revenues.
While an interest coverage ratio of 1.5 is acceptable, analysts and investors prefer two or higher. The interest coverage ratio may not be considered favorable for firms with historically more volatile revenues unless it is significantly higher than three.
What Does a Negative Interest Coverage Ratio Indicate?
Any figure less than one indicates a poor interest coverage ratio, implying that the company’s current earnings are insufficient to cover its existing debt. Even with an interest coverage ratio less than 1.5, a company’s ability to meet its interest expenses on a continuous basis is uncertain, especially if the company is prone to seasonal or cyclical income troughs.