One of the important financial ratios while talking about a company’s debt situation is the interest coverage ratio or ICR. It is a tool that proves itself useful to not just the lender and the company but also to investors who may be thinking of buying stocks of the company.

So, what exactly is interest coverage ratio?

A company has to make payment of interest on its debt. How many times it can make this payment with its earnings before interest and taxes is the ICR. There is a formula to calculate ICR. It is EBIT / interest expenses (EBIT). EBIT is the operating profit of a company. It provides a genuine indication of the company’s ability to pay an interest. The ICR ratio is indicative of the extent of debt borne by a company.

An example of application of the interest coverage ratio formula will help understand the concept better:

Company X has earnings of Rs 6,00,000 for the last quarter. It has to pay Rs 20,000 each month for debts it owes. The earnings are the company’s operating profits which are calculated by deducting cost of goods sold and operating expenses from the revenues earned. So, if the revenues earned are Rs 8,00,000 and cost of goods sold amounts to Rs 1,00,000 and operating expenses are another Rs 1,00,000, then the EBIT is Rs 6,00,000.

So, to compute ICR, you would need to turn the monthly payment of interest into quarterly (Rs 30,000×3 = Rs 90,000). The company’s ICR would be Rs 6,00,000/Rs 60,000 = 6.66. This means the company’s earnings are adequate to make interest payments 6.66 times.

Typically, when the ICR stands at 1.5 or less, it means the company may not be in a good position to meet expenses related to interest payment. Companies would need to have adequate earnings to cover these expenses so as to face the future. Shareholders would need to track this ratio to understand if their investment in the company will hold them in good stead.

What is the ideal interest coverage ratio?

An interest coverage ratio of at least 2 is treated as an acceptable one for companies that are known to have steady and good revenues. Anything over 3 is even better. On the other hand, if the ratio drops below 1, it means the company is in no position to meet its interest payments and is not in a good position financially. If the ratio is at 1, it means the company has earnings that will just about make interest payment possible. Although there is no ideal interest coverage ratio, the better it is the greater the ability of the company to repay debt comfortably.

While analysing the ideal interest coverage ratio, it helps to do a comparative analysis of the company’s past performance, of say about five years. When you see a steadily growing ICR, it means the company’s financial health is stable. On the other hand, if the ICR has declined over the years, it shows that the company may face a liquidity issue in the near future.

Uses of interest coverage rate

– Interest coverage ratio formula is used by creditors and lenders to understand the risk involved in lending to a company.

– As mentioned earlier, it is also used by investors to assess if the company they are investing in is doing well financially.

– Borrowing is not necessarily a negative attribute if a company uses it smartly, ie, to build assets and grow. Interest payments impact profitability and a company should know that it can handle these payments consistently. The ICR is an apt metric to understand if the company can handle borrowing.

– It must be noted that ICR, while being an excellent ratio, can also have some limitations. It may vary from industry to industry and different ratios may be acceptable in different industries. Also, when comparing, companies operating within the same industry should be used rather than companies in different industries, conditions and business models.

Conclusion

Interest coverage ratio is a metric used to analyse the financial health of a company. The interest coverage ratio formula is:  EBIT/interest expenses where EBIT is earnings before interest and taxes. A good ICR of above 2 or 3 is preferable while an ICR below 1 shows that all may not be well with a company. ICR is used by lenders, investors and creditors to assess a company’s financial well-being.