Interest Coverage RatioDefined along with Formula & How to Calculate

Written By:
Lisa Borga

The interest coverage ratio (ICR), also often known as the times interest earned ratio, is a financial ratio that measures the number of times a company is capable of paying interest on outstanding debt with its earnings before interest and taxes (EBIT).

This is one of the most important financial ratios for gauging the riskiness of certain investments.

The ICR is valuable for investors, banks, and creditors in order to measure a business’s capability to repay its present debts as well as its ability to take on new obligations.

How the Interest Coverage Ratio Works

The ICR measures how long a company is capable of making interest payments based upon its current obligations and available earnings.

Typically, the measurement period used will be fiscal quarters or years.

The formula for calculating the ICR is:

Interest Coverage Ratio = EBIT / Interest Expense

The lower a company’s resulting ratio is after calculating the interest coverage ratio, the greater its debt burden is.

This means that it has less capital available for use and that in cases where the ratio is particularly low, such as 1.5 or less, it may not be able to meet its interest expenses.

A company needs earnings high enough to both cover its interest payments and to cover any unexpected expenses that come up.

The ability of a company to cover its interest expenses is a critical facet of solvency and, as a result, is a crucial part of the company’s ability to generate returns for its shareholders.

Why the ICR Is Important

For all companies, the capacity to cover interest expenses is a primary concern.

Once a company begins to struggle to meet its interest payments, it could be forced to borrow more funds or to utilize cash reserves, and this money would be far better spent investing in other profitable ventures or for covering unexpected future expenses.

Though considering a company’s ICR over one period can be a valuable indicator of a company’s health, it is far better to look at several of these ratios calculated over a period of time.

This can offer a far better picture of how a company is performing relative to its past performance, as well as how it might be heading.

By looking at the interest coverage ratio over a period of several years, an investor could see if the ratio has been declining, remaining stable, or improving.

This can provide a valuable picture of a business’s financial health and how its management is performing.

Additionally, in some cases, investors or banks may be accepting of or even seek out companies with high-interest ratios.

In these cases, they may be able to purchase bonds or lend money at greater interest rates due to the high ICR.

Example of the ICR – Interest Coverage Ratio

Assume that in a company’s fiscal quarter, its earnings before income and taxes were $500,000.

Also, assume that this company had debts for which it must make payments of $50,000 monthly.

In order to find this company’s ICR, we must first find what the company’s interest liability would be for a fiscal quarter by multiplying $50,000 by three.

This results in a quarterly interest payment of $150,000.

Now we can find the ratio by dividing the company’s earnings by the quarterly interest payments.

This is:

$500,000 / $150,000 = 3.33

This rate shows that the company still has an acceptable degree of liquidity.

Generally, an ICR of 1.5 is considered the lowest acceptable ratio below which most banks will be unwilling to accept the risk of lending a company additional funds.

At this point, the risk of default is generally considered unacceptably high.

If the interest coverage ratio is lower than one, this indicates that a company will struggle to meet its interest obligations and is likely to need to utilize its reserves of cash to be able to cover the expense.

If a company is unable to do this, it may have to declare bankruptcy.

Variations on the Interest Coverage Ratio

There are several variations of the formula for calculating the ICR, and two prominent options stand out.

Investors should understand these two variations before comparing the different companies’ ratios.

These variants come from using alternatives to EBIT.

EBITDA

The first and most prominent variation on the formula for the interest coverage ratio uses earnings before interest, taxes, depreciation, and amortization.

(EBITDA) in place of EBIT.

Because the numerator does not include depreciation and amortization but does not change interest expense in the denominator, the resulting ratio will be higher.

EAT

The second variation, earnings before interest after taxes (EBIT), accounts for the important role that taxation plays in a company’s financial situation.

This adjusts the formula to subtract a company’s tax burden from the top of the equation but still does not adjust the interest expense of the denominator.

As a result, this produces a smaller ratio than when using regular formula.

Limits of the ICR

As with any financial metric, the ICR has its own limitations that should be kept in mind.

Investors should be aware of these before using this ratio to make any decision.

First of all, the degree to which firms are able to cover interest expenses is highly sensitive to industry norms as well as for even measuring between companies.

A well-established company with consistent earnings could safely have an ICR of only two.

A good example of this is utility providers that generally have extremely consistent revenue and expenses.

As a result, even utility providers with a low ICR may be able to consistently meet interest payments.

However, certain industries, including technology, face much more volatility, and as a result, the minimum ICR banks and investors may find acceptable could be much higher, often three or greater.

Often these companies will see significant fluctuations in sales and expenses and, as a result, require a greater degree of capability to cover interest payments during periods with lower revenue.

Due to the wide disparity in acceptable interest coverage ratios between different industries, it is important to account for any particular company’s peers when considering their ratio.

Whenever possible, it is also best to consider companies that are similar in terms of revenue.

Also, to gain a clear and accurate picture of a company’s actual position, all debts should be included when calculating their ICR.

However, in some cases, companies may decide not to include certain items of debt when calculating this ratio.

As a result, it is important to ensure all debts are included when making judgments based on this ratio.

What Can You Learn From the ICR?

The ICR measures the ability of an organization to meet its debt obligations.

This metric provides investors a valuable picture of a business’s financial standing.

The interest coverage ratio tells how many times over for a given period, typically measured in fiscal years, a company is able to make interest payments using its current available earnings.

How Can the Interest Coverage Ratio Be Calculated?

The most common way to calculate the ICR of a company is to divide EBIT by the interest on the current debt for a particular period.

Typically this will be for a fiscal year.

What Is a Good ICR?

Though an optimal ICR will depend on the particular industry and company, any ratio greater than one shows that a firm is currently able to cover its current debts.

However, most investors prefer a ratio of two or above.

An ICR below 1.5 is generally considered risky, and in some industries with a greater record of volatility, an ICR of less than three may be considered poor.

What Can a Low ICR Tell You?

An ICR of below one means that a business’s earnings are not sufficient to service outstanding debts.

Though in some cases, a company’s fortunes may improve, allowing it to remain in business, this is considered a significant risk for investors and lenders that could indicate that a business is at a high risk of future bankruptcy.

Key Highlights

• The ICR measures the ability of a company to pay interest on its current debt.
• The ideal ICR will vary based on industry, but typically a higher ratio is preferable.
• In order to calculate the ICR, a firm’s earnings before interest and taxes (EBIT) is divided by the period’s interest expense.
• There are several ways to calculate ICR, and some formulas will use EBIAT or EBITDA as an alternative to EBIT.