What is Interest Coverage Ratio (ICR)?

The interest coverage ratio, or ICR, is one of the most important financial ratios when discussing a company's debt situation. This tool is useful not only for the lender but also for investors looking to buy stocks of the company.

What is the interest coverage ratio ?

A company must pay interest on its debt. The ICR is the number of times a company can pay this amount with its earnings before taxes and interest. It is easy to calculate ICR using a formula. It is EBIT / Interest expenses (EBIT). EBIT refers to the company's operating profit. It is a reliable indicator of a company's ability pay interest. The ICR ratio shows how much debt a company has.

A example of the interest coverage formula will help you understand the concept better:

For the quarter ended December 31, 2016, Company X earned Rs 6,00,000. It must pay Rs 20,000 per month to cover its debts. Earnings are the company's operating profit. They are calculated by subtracting the cost of goods sold from the revenue earned. If the revenue earned is Rs 8,00,000. The cost of goods sold is Rs 1,00,000. Operating expenses are Rs 1,00,000. This gives the EBIT a value of Rs 6,00,000.

To calculate ICR, convert the monthly interest payment into quarterly payments (Rs 30,000x3 = R 90,000). ICR for the company would be Rs 6,00,000./Rs 60,000. = 6.66. This means that the company's earnings can make 6.66 times interest payments.

The ICR is usually 1.5 or lower. This means that the company might not be able to pay interest payments. To be able to meet these expenses, companies would need sufficient earnings. This ratio would be used by shareholders to determine if they will benefit from their investment in the company.

What is ideal interest coverage ratio ?

Companies with steady, good revenue are considered acceptable if their interest coverage ratio is at least 2. Anything above 3 is better. If the ratio falls below 1, it indicates that the company is unable to pay its interest payments. This is also a sign that the company is financially unsound. A ratio of 1 means that the company has enough earnings to make the interest payments possible. There is no perfect ratio for interest coverage, but the higher it is, the more the company can repay its debts comfortably.

It is helpful to compare the past performance of the company, for example, over five years, when determining the ideal interest coverage ratio. If the ICR is steadily increasing, it indicates that the company's financial position is stable. If the ICR drops over time, it could indicate that there may be a liquidity problem in the near future.

Uses Interest Coverage Rate

Creditors and lenders use the interest coverage ratio formula to calculate the risk of lending to companies.

Investors can also use it to determine if the company is financially sound, as we mentioned.

If a company uses its borrowing smartly to grow and build assets, it is not necessarily a bad thing. A company must be able to pay its interest payments on a consistent basis. This will impact its profitability. To understand whether a company is able to handle borrowing, the ICR is a good indicator.

It is important to note that ICR can have limitations. It can vary from one industry to another, and different ratios may be acceptable for different industries. When comparing companies, it is better to use companies within the same industry than those in different industries, conditions, and business models.

Conclusion

The interest coverage ratio is a measure that can be used to assess the financial health and stability of a company. EBIT/interest expenses is the formula for interest coverage ratio. EBIT is earnings before taxes and interest. An ICR above 2 or 3 is preferred, while a lower ICR may indicate that things are not going well for a company. Lenders, investors, and creditors use ICR to evaluate a company's financial health.