Interest coverage ratio (ICR) explicitly measures a company’s capacity to make interest payments on debts. This is calculated by dividing the company's earnings before interest and taxes (EBIT) by the company's interest expenses for the same period. This helps lenders assess its short-term financial situation.
ICR is also known as interest coverage, debt service ratio, or debt service coverage ratio. The formula for calculating ICR is:
Interest coverage ratio = EBIT/interest expenses
If the interest ratio is lower than 1, it indicates the company has a higher debt burden with a high possibility of bankruptcy or default. Lower ICR ratio means that the company’s earnings are meager and can be subject to interest rate increase.
If the ratio is lower than 1.5, the company’s position is questionable, and it also hinders the chance of securing extra credit from prospective creditors.
If the ratio is more than 1.5, the company’s is on a well-earning curve. A higher ratio will indicate the company’s financial health and, at the same time, will mean that it is not taking risks or leveraging too much to magnify its earnings.
Investors use ICR to determine the security of investments and whether the company is capable of handling the extra debt (interest payments). Creditors use this ratio to check the financial health of the company, while bankers use it to determine its creditworthiness.
The analysis of ICR, among other bank stipulations, helps lenders assess the borrower’s credibility and their capacity to service a loan. Many banks and financial institutions have these type of ratios as part of their loan agreement. If the company fails to satisfy these conditions, the bank might reject the loan.
As the banking sector is now heavily ridden with debts from major sectors, the importance of ICR is on the rise. Banks and financial institutions want to know for sure if the borrower is in a position to handle the debt and related expenses. The level of corporate leverage of a company and its market standing have become essential parameters when evaluating potential setbacks.
However, ICR has no optimum number to indicate that the company has a profit-earning potential to manage its interest payments and debts.
A favorable ICR position would depend on the sector the business belongs to, its market, and the potential of the products it offers. If the company has reliable sales revenue sources, a lower ICR might not be of importance even when the market is down.
ICR provides a margin of safety and guarantees to investors and creditors by informing them of the company’s financial position.