Interest Coverage Ratio
An Interest Coverage Ratio (ICR) is a financial ratio that evaluates a company’s ability to repay its outstanding debt. ICRs are used by both lenders and investors to evaluate a company’s credit risk. An interest coverage ratio is also known as a “times interest earned” ratio.
Interest coverage ratios determine the risk associated with lending funds to a company, based on the ability of the company to pay the interest on its existing debt. A high ratio indicates that a company can cover its interest expense several times over, while a low ratio indicates a company may have trouble repaying its loans. An interest coverage ratio trend line is useful for spotting situations where a company’s results or debt burden are contributing to a downward trend in the ratio.
Interest Coverage Ratio Formula
The formula to calculate interest coverage ratio is as follows:
- Interest Coverage Ratio = EBIT Interest Expenses
- EBIT is the company’s operating profit (Earnings Before Interest and Taxes)
- Interest expense represents the interest payable on any borrowings such as bonds, loans, lines of credit, etc.
Uses of Interest Coverage Ratio
- Interest coverage ratios are used to determine the ability of a company to pay its interest expense on outstanding debt.
- An ICR is used to determine whether lending money to the company is a risky endeavor.
- The trend analysis of ICR gives a clear picture of the stability of a company in terms of interest payments.
- The ICR is used to determine a company’s short-term financial health.
Types of Interest Coverage Ratios
The interest coverage ratio is subject to two somewhat common variations, based on alterations to EBIT, that must be considered before studying companies’ ratios.
Earnings before interest, taxes, depreciation and amortization (EBITDA):
The interest coverage ratio can also be calculated based on earnings before interest, taxes, depreciation, and amortization (EBITDA) rather than EBIT. Depreciation and amortization are excluded from this variation, so the numerator will often be higher in calculations using EBITDA than in those using EBIT. Using EBITDA will result in a higher interest coverage ratio than using EBIT, since interest expenses will be the same in both cases.
Earning before interest after tax (EBIAT):
Another variation uses earnings before interest after taxes (EBIAT) instead of EBIT to calculate interest coverage ratios. Its effect is to deduct tax expenses from the numerator in order to show the ability of a company to pay its interest expenses in a more accurate way. In addition to taxes, EBIAT can be used instead of EBIT to calculate interest coverage ratios for a better understanding of a company’s ability to cover its interest expenses.
Example of the Interest Coverage Ratio
ABC Company earnings $5,000,000 before interest and taxes in its most recent reporting month. Its interest expense for that month is $2,500,000. Therefore, the company’s interest coverage ratio is calculated as:
$5,000,000 EBIT ÷ $2,500,000 Interest expense
= 2:1 Interest coverage ratio
The ratio indicates that ABC’s earnings should be sufficient to enable it to pay the interest expense.
Accounting Tools. (2022, March 17). Retrieved from Accounting Tools: https://www.accountingtools.com/articles/interest-coverage-ratio
Hayes, A. (2021, October 5). Investopedia. Retrieved from Investopedia: https://www.investopedia.com/terms/i/interestcoverageratio.asp