Interest Coverage Ratio Formula – Why it is Useful and How to Calculate

The interest coverage ratio measures how many times a company can cover its current interest payment with its available earnings. In other words, it measures the margin of safety a company has for paying interest on its debt during a given period. The interest coverage ratio is used to determine how easily a company can pay their interest expenses on outstanding debt.  The lower the ratio, the more the company is burdened by debt expense. When a company’s interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses comes into question.

Companies need to have more than enough earnings to cover interest payments.  This cushion helps them to survive uncertain and unforeseeable financial obstacles that may arise. A company’s ability to meet its interest obligations indicates its health and solvency.  It is an important measure for investors and a factor in the available return for shareholders.

ICR Interpretation

Measurement over time can reveal information about a company’s health an its future trend.   Looking at a single interest coverage ratio may tell a good deal about a company’s current financial position.  But, analyzing interest coverage ratios over time will often give a much clearer picture of a company’s position and trajectory.

If the data is available, analyze interest coverage ratios on a quarterly basis for the past five years.  Trends may emerge and give an investor a much better idea of whether interest coverage ratios are improving or declining.  Or maybe reveal that an average looking current interest coverage ratio is really quite stable. The ratio may also be used to compare different companies when other factors appear equal.  Identifying the one that can pay its debts more easily can be helpful when making an investment decision.

Generally, stability in interest coverage ratios is one of the most important things to look for. A declining interest coverage ratio is often something for investors to be wary of.  It indicates that a company may be unable to pay its debts in the future.  Understandint the decline can pinpoint if the problem is internal or caused by larger economic conditions.  Overall, the interest coverage ratio is a good assessment of a company’s short-term financial health. Nevertheless, it is only a tool.  It is a good way of assessing a current investment opportunity.  But, many other factors should be considered when making investment decisions.  Also, past performance cannot guarantee future results.  It is difficult to accurately predict a company’s long-term financial health with any ratio or metric.

ICR Analysis

Interpreting and acting on the data depends largely on how much risk the creditor or investor is willing to take. Depending on the desired risk limits, a bank might be more comfortable with a different number than an investor. But, regardless of the results you are looking for, the basics of this measurement don’t change.

• ICR Less than 1 – If the computation is less than 1, it means the company isn’t making enough money to pay its interest payments. At less than 1, don’t even think about making any principle payments on the debt. A company with a calculation less than 1 can’t even pay the interest on its debt. This type of company is extremely risky and should be avoided by both lenders and investors.
• ICR Equal to 1 – If the coverage equation equals 1, it means the company makes just enough money to pay its interest. This situation isn’t much better than the last one.  The company still can’t afford to make the principle payments. It can only cover the interest on the current debt when it comes due.
• ICR Greater than 1 – If the coverage measurement is above 1, it means that the company is making more than enough money to pay its interest obligations.  There is also some extra earnings left over to make the principle payments. Most creditors look for coverage to be at least 1.5 before they will make any loans. In other words, banks want to be sure a company make at least 1.5 times the amount of their current interest payments.

The interest coverage ratio at a single point in time can reveal information about the company’s ability to service its debt.  However, analyzing the ratio over time provides a clearer picture. Is debt becoming a burden on the company’s financial position?  Or, is the company becoming stronger with increased earnings year over year? A declining interest coverage ratio is something for investors to concerned about.  It indicates that a company may be unable to pay its debts going forward.  That is not a good trend and it must be corrected by management for the company to stay solvent.

Remember, though, it is impossible to accurately predict a company’s long-term financial health with any ratio or metric. Different analysts look for different results.  Some banks or potential investors may actually be comfortable with a less desirable ratio.  Their research might indicate the company is stable, but they can charge a higher interest rate on any additional extended credit.

Suppose a company’s earnings during a given quarter are $500,000 and that it has debts which require interest payments of $50,000 every month. To calculate the interest coverage ratio, first convert the monthly interest payments into quarterly payments by multiplying them by three.

The interest coverage ratio for the company is $500,000 / ($50,000 x 3) = $500,000 / $150,000 = 3.33.

Keeping this ratio solidly above 1 is a critical and ongoing concern for any company.  Once a company struggles making its debt payments, it may have to borrow further or dip into its cash reserves.  The lower a company’s interest coverage ratio is, the more its debt expenses burden the company. When a company’s interest coverage ratio is 1.5 or lower, many banks and investors will conclude the company is risky.  A result of 1.5 is generally considered to be a bare minimum acceptable ratio for a company.  It is a tipping point below which lenders will likely refuse to lend the company more money.  At this level, the company’s risk for default may be perceived as too high.

Moreover, an interest coverage ratio below 1 indicates the company is not generating sufficient revenues to satisfy its interest expenses. If a company’s ratio is below 1, it will likely need to spend some of its cash reserves in order to meet the difference or borrow more, which will be difficult for reasons stated above. Otherwise, even if earnings are low for a single month, the company risks falling into bankruptcy. A good interest coverage ratio would serve as a good indicator of this circumstance and potentially as an indicator of the company’s ability to pay off the debt itself as well. Large corporations, however, may often have both high-interest coverage ratios and very large borrowings.

With the ability to pay off large interest payments on a regular basis, large companies may continue to borrow without much worry. Businesses may often survive for a very long time while only paying off their interest payments and not the debt itself. Yet, this is often considered a dangerous practice, particularly if the company is relatively small and thus has low revenue compared to larger companies. Moreover, paying off the debt helps pay off interest down the road, as with reduced debt the company frees up cash flow and the debt’s interest rate may be adjusted as well. (Source: investopedia.com)

There are a couple of somewhat common variations of interest coverage ratio that are important to consider before studying the ratios of companies. These variations come from alterations to EBIT in the numerator of interest coverage ratio calculations.

• EBITDA vs EBIT – One variation uses earnings before interest, taxes, depreciation, and amortization (EBITDA) instead of EBIT in calculating the interest coverage ratio. Because this variation excludes depreciation and amortization, the numerator in calculations using EBITDA will often be higher than those using EBIT. Since the interest expense will be the same in both cases, calculations using EBITDA will produce a higher ICR ratio than calculations using EBIT will.
• EBIAT vs EBIT – Another variation uses earnings before interest after taxes (EBIAT) instead of EBIT. This has the effect of deducting tax expenses from the numerator.  It attempts to be a more accurate picture of a company’s ability to pay its interest expenses. Taxes are an important financial element to consider for a clearer picture of a company’s debt management.  To address this, you can use EBIAT in calculating interest coverage ratios instead of EBIT.
• EBIT vs Net Income – Earnings before interest and taxes is essentially net income with the interest and tax expenses added back in. The reason EBIT is used instead of net income is because it provides a truer representation of how much the company can afford to pay in interest. With net income, the calculation would be screwed.  Interest expense would be counted twice and tax expense would change based on the interest being deducted. To avoid this problem, just use the earnings or revenues before interest and taxes are paid.

Limits to Using ICR

Interest coverage ratio, while helpful, is hardly the definitive tool for determining a company’s health. If you look at ICR by itself, you could miss a lot of contextual information.

• Does no Account for seasonal fluctuations – For example, if you’re looking at a quarterly ICR, it could be a poor season for that particular industry, and thus not an ideal way to gauge the overall health of the company.  The big limitation to ICR, ultimately, is that
• EBIT doesn’t deduct taxes. It can be helpful to have an idea of what the earnings pre-tax look like compared to the interest expense, but if a lot of the company’s gross profit goes to income taxes, that’s a huge part of the story that is not getting represented in ICR, and might prevent you from knowing the whole story about a company’s financial situation.  As a result, some may be more inclined to use earnings before interest after tax (EBIAT) when calculating ICR instead of EBIT to show a different side.
• ICR not consistent from industry to industry – Some industries can be more volatile than others. Standards for what is and is not an acceptable ICR can vary as a result. As such. interest coverage ratio is best treated as one of several tools one should use when judging how risky an investment is.
• Does not consider debt structure – Depending on the terms established on the business’ debt, investors and analyst must look carefully into how interest charges are paid on the outstanding debt, to make sure the Interest Coverage ratio is accurate. Some loans may offer a business the possibility to defer interest payments for a year or sometimes even more. During this period, if the ICR is calculated by using the interest expenses paid during the year, the ratio will be overestimated and therefore it will paint a distorted picture of the business actual capacity to fulfill its commitment.

IRC – General Guidelines for Investing 

Conclusion

The Interest Coverage Ratio illustrates how healthy a company is when it comes to meeting its current financial commitments. Companies with a large debt incur substantial interest expenses.  These expenses have to be paid by the revenues generated by the business.  If the business performs poorer than expected, the company’s ability to fulfill its interest expenses is affected.  ICR should not be used alone.  There are other important debt ratios that can provide additional insight:

• Debt-to-Assets ratio – measures the percentage of a business’ total assets that are financed through debt.
• Debt Service ratio – measures the coverage of all debt-related payments that are due in the next 12 months
• Fixed Charges Coverage Ratio – measures the number of times a business’ fixed charges including leases, insurance premiums and other similar expenses.

Analyzing these metrics will provide a fairly accurate picture of how leveraged a business is.  Also, what its current payment capacity is in order to properly value its debt.  These metrics will help to decide if it would be advisable to invest or to extend a loan.

The lower the ratio, the higher the company’s debt burden and the greater the possibility of bankruptcy or default.

• IRC Below 1.0 – An interest coverage ratio below 1.0 indicates the business is having difficulties generating the cash necessary to pay its interest obligations (i.e. interest payments exceed its earnings (EBIT)). A lower ICR means less earnings are available to meet interest payments and that the business is more vulnerable to increases in interest rates.
• Low IRC – When a company’s interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable.
• A higher ratio indicates a better financial health as it means that the company is more capable to meeting its interest obligations from operating earnings. On the other hand, a high ICR may suggest a company is “too safe” and is neglecting opportunities to magnify earnings through leverage.

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