The interest coverage ratio is also called the “times interest earned” ratio. The interest coverage ratio measures a company’s ability to handle its outstanding debt. It is one of a number of debt ratios that can be used to evaluate a company’s financial condition. The term “coverage” refers to the length of time—ordinarily, the number of fiscal years—for which interest payments can be made with the company’s currently available earnings.
This is why looking at a business’ interest coverage ratio is important for lenders and investors. Looking at a single ratio in isolation may show a lot about a company’s current financial position. However, it is far more beneficial to track the ratio over a longer period of time. This ratio is used to help understand a business’ margin of safety for paying the interest on its debt over any given period of time. It is often used by creditors, investors and lenders to judge the risk of lending any amount of capital to a business. The lower the interest coverage ratio, the greater the company’s debt and the possibility of bankruptcy.
Interest coverage ratio formula
J.B. Maverick is an active trader, commodity futures broker, and stock market analyst 17+ years of experience, in addition to 10+ years of experience as a finance writer and book editor. Usually, when practitioners standardized earnings surprise mention the “interest coverage ratio”, it is reasonable to assume they are referring to EBIT. Access and download collection of free Templates to help power your productivity and performance.
- Any financial ratios will not give a clear picture when analyzed on a stand-alone basis.
- The ICR ratio is calculated by dividing a company’s EBIT by its interest expense.
- A ratio of just 0.5x, by contrast, would mean that a company is spending twice as much on interest as it earns in EBIT every year.
- Based on the above amounts, the corporation’s annual income before interest and income tax expenses is $900,000 (net income of $650,000 + interest expense of $150,000 + income tax expense of $100,000).
Many banks and lenders generally have ICR as part of their due diligence for loans. If you intend to use this measurement, there is one issue to be aware of. Like other financial ratios, it isn’t easy to forecast a company’s long-term financial standing with an interest coverage ratio.
Although, not part of the chart shown above, tech companies like Facebook, Google ( Alphabet) and Microsoft do not have significant borrowings on their balance sheet. In our example 3, let us calculate the interest coverage ratio for Walmart Inc using excel. This is because depreciation and amortization expense in the case of company B is 20 million ( almost double of Company A) which lead to lower EBIT. But, in this interest coverage ratio example, we will calculate using EBITDA in the numerator instead of EBIT. Graham believed the interest coverage ratio to be a part of his “margin of safety.” He borrowed the term from engineering. For instance, when a 30,000-pound-capacity bridge is constructed, the developer may say that it is built for only 10,000 pounds.
Is there a danger if a company has an ICR that is too low?
Any financial ratios will not give a clear picture when analyzed on a stand-alone basis. Hence, ICR must be calculated using EBITDA if the company is having significantly high depreciation and amortization expense. The main reason why EBITDA may be considered instead of EBIT is that with EBITDA the earnings are not influenced by non-cash expenses such as depreciation and amortization expenses. Often used as a covenant, lenders rely heavily on this ratio as it helps lenders in evaluating if the companies are making profits to cover the interest expenses.
Interest Coverage Ratio – Meaning, Types, Interpretation & Importance
Generally, the interest coverage ratio is calculated using a company’s earnings before interest and taxes (EBIT) divided by its annual interest expense. A coverage ratio, broadly, is a metric intended to measure a company’s ability to service its debt and meet its financial obligations, such as interest payments or dividends. The higher the coverage ratio, the easier it should be to make interest payments on its debt or pay dividends. The trend of coverage ratios over time is also studied by analysts and investors to ascertain the change in a company’s financial position. This financial metric is widely used in business to measure a company’s ability to repay its debts.
Interest Expenses
A creditor, on the other hand, uses the interest coverage ratio to identify whether a company is able to support additional debt. If a company can’t afford to pay the interest on its debt, it certainly won’t be able to afford to pay the principle payments. Thus, creditors use this formula to calculate the risk involved in lending.
It’s a simple yet powerful indicator of a company’s financial health, and understanding it can be crucial for investors, lenders, and credit analysts. The asset coverage ratio (ACR) evaluates a company’s ability to repay its debt obligations by selling its assets. In other words, this ratio assesses a company’s ability to pay debt obligations with assets after satisfying liabilities. An ASR of 1 means that the company would just be able to pay off all its debts by selling all its assets. An ASR above 1 means that the company would be able to pay off all debts without selling all its assets.
Its straightforward calculation made it easy to understand, and its relevance to the ability of a company to pay its interest expenses made it a valuable tool for evaluating a company’s creditworthiness. The interest coverage ratio is calculated by dividing the earnings generated by a firm before expenditure on interest and taxes by its interest expenses in the same period. The ICR is also known as the debt service ratio or debt service coverage ratio. It may be calculated as either EBIT or EBITDA divided by the total interest expense of the company.
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Therefore, the company would be able to pay off all of its debts without selling all of its assets. This helps in understanding if how is the company performing when compared to other competitor or industry as a whole. It is also important to compare the Interest coverage ratio of the company with other similar companies in the same industry.
In contrast, a low-interest coverage ratio may indicate that a company struggles to pay its interest expenses and may be at risk of defaulting on its debt. To analyse a firm’s financial statements, individuals should use the interest coverage ratio along with other metrics like – quick ratio, current ratio, cash ratio, debt to equity ratio, etc. It will help maximise the benefits of the said metric and will enable to cushion the shortcomings more effectively. In simple words, the interest coverage ratio is a metric that enables to determine how efficiently a firm can pay off its share of interest expenses on debt.