What is The Interest Coverage Ratio (ICR)?

With rising interest rates and economic uncertainty, many companies need help to service their outstanding debt obligations. However, determining whether a company can realistically pay the interest on its loans and bonds need not be a mystery. Learning how to calculate and interpret the interest coverage ratio can provide crucial insights into a company’s financial health.

Read on to understand what the interest coverage ratio is, how to compute it, and why it matters when evaluating a company’s ability to handle its debts. Learn how to identify companies that are most likely to default on their debts and make informed investment choices by understanding the interest coverage ratio.

Understanding Interest Coverage Ratio? 

The interest coverage ratio (ICR) is a computation of how easily a company will pay the interest on its debt using its available earnings. It compares a company’s earnings before paying interest and taxes to the amount of interest it owes on loans and bonds.

A higher ICR means a company is better able to pay its debts, even during tough economic times. However, if a company’s ICR is low, it may need help to make its interest payments, which increases the risk of bankruptcy.

The ICR formula helps us understand how well a company can pay its debts.

Calculating the Interest Coverage Ratio

The interest coverage ratio formula is used to evaluate an organisation’s ability to pay its debts. It does this by comparing the amount of money a company makes (before paying taxes and interest) to the amount of money it spends on interest payments.

For instance, let’s say a company named ABC Ltd earned ₹50 lakh last year and paid ₹25 lakh in interest payments. Using the interest coverage ratio formula, we can determine that ABC Ltd can cover its interest payments comfortably.

Interest Coverage Ratio = EBIT / Annual Interest Expenses

= ₹50 lakh / ₹25 lakh = 2

So ABC Ltd’s interest coverage ratio is 2. This means its EBIT was enough to cover annual interest payments two times over.

Types of Interest Coverage Ratio

Other methods of computing the interest coverage ratio exist besides EBIT. For example, metrics like EBITDA minus capex, EBIAT, fixed charge, and EBITDA can be employed.

• EBITDA Interest Coverage Ratio

The coverage ratio determines the number of times that EBITDA (earnings before interest, tax, depreciation, and amortisation) can pay for interest expenses.

• Fixed Charge Coverage Ratio (FCCR)

FCCR assesses the ability of the business to meet all of its immediate financial obligations.

• EBITDA Less Capex Interest Coverage Ratio

This ratio can determine how often EBITDA can be used to pay interest expenses after capital expenditure deductions.

• EBIAT Interest Coverage Ratio

EBIT can also be substituted with earnings before interest and taxes. It provides an unambiguous indication of the company’s capacity to cover loan interest.

Interpreting Interest Coverage Ratio Results 

The interest coverage ratio is a measure of how financially stable a company is. A higher ratio means the company is in better shape, while a lower ratio means there may be more risks involved. Nevertheless, what is considered a “good” ratio can vary depending on the industry in which the company operates:

As a rule of thumb for most companies:

• Ratios below 1 indicate an inability to meet interest obligations currently
• Minimum adequate coverage is around 2
• Strong coverage is 3 or higher
• The above 10 are exceptionally comfortable

However, some capital-intensive industries, like utilities, routinely have lower ratios. Extremely high ratios (say, above 50) could mean overly conservative financing and underutilised leverage capacity.

Why Does Interest Coverage Matter to Various Stakeholders?

Importance for Creditors

When a company needs to borrow money from a bank or other lender, the lender will look at something called the “interest coverage ratio” to decide if they should approve the loan. This ratio helps the lender figure out if the company will be able to pay back the loan on time. If the ratio is high, it means the company is in a good position to take on more debt, but if the ratio is low (below 1), the company might need help paying back the loan.

Importance for Investors 

When considering investments in the stock market, it’s important to evaluate companies that have sufficient revenue to cover their debts. This is called “high-interest coverage,” and it means that the company has enough money left over after paying its bills to invest in new projects, buy back its stock, or pay dividends to its shareholders. On the other hand, if a company doesn’t make enough money to pay its debts, it could be in trouble financially, and that would not be good news for its shareholders.

Limitations of the Interest Coverage Ratio Metric

While interest coverage ratio insights are useful, over relying on this one number in isolation can be problematic while analysing companies. Key limitations to note include:

• Difficult Comparability Across Industries: Acceptable coverage varies drastically between sectors, curbing apples-to-apples comparisons
• No Outlook on Debt Repayment: While interest expenses may be covered, poor cash flow could still inhibit actually paying down principal debt balances
• EBIT Fluctuations: Volatile earnings leading to fluctuating coverage ratios may wrongly signal financial instability
• Complex Capital Structures: Intricate intercompany debt obligations within partnerships can distort simplified coverage calculations

The interest coverage ratio is a financial tool that helps us understand how well a company can pay its debts. However, it’s important to remember that this ratio is just one part of the bigger picture. By looking at other indicators, like how much debt a company has compared to how much it’s worth, we can get a clearer idea of its overall financial health.

Key Takeaways: Evaluating Interest Coverage More Effectively

Now that you understand the intuition behind the interest coverage ratio (ICR), let’s recap key lessons for putting this knowledge into practice:

• The interest coverage ratio formula divides EBIT by the total annual interest owed across all debts
• Higher ratios indicate a better ability to meet interest obligations, with a minimum adequate coverage ratio of around 2
• Compare companies within the same industries since acceptable coverage varies significantly between sectors
• Combine insights from interest coverage with other financial metrics for a more complete assessment
• Monitor coverage ratio trends over time rather than relying on a single snapshot

Check a company’s interest coverage ratio to understand its financial health. It’s an important metric often overlooked.

Conclusion

It is important to keep track of interest coverage when making investment and lending decisions. This helps you make smarter choices, especially during times when the economy is uncertain and it is harder to repay debts. By staying on top of interest coverage, you can make better decisions that will help you avoid financial trouble.

Frequently Asked Questions

What is the formula for calculating the interest coverage ratio?

To calculate it, you take a company’s EBIT (earnings before interest and taxes), expressed in rupees, and divide it by their total annual interest expense on debts like loans and bonds.

What interest coverage ratio level is considered financially healthy?

Generally experts prefer to see ratios of at least 2, indicating a company’s earnings can cover interest expenses twice over. Ratios below 1 signal potential inability to pay interest obligations.

Why is the interest coverage ratio important for creditors and investors?

Creditors use the ratio to measure if companies can handle more debt. Investors want to see healthy ratios showing excess profits that can fund growth and shareholder returns.

Does the interest coverage ratio have any limitations?

Yes – it can’t be easily compared across industries, doesn’t show the ability to repay principal, and fluctuates with earnings changes. Using other metrics creates a more complete picture.

How can the interest coverage ratio be used effectively?

Compare with care to same-industry peers, track trends over time, and incorporate complementary financial ratios like debt-to-equity ratios for mighty insights.