What is Interest Coverage Ratio? Why it is important to know?
‘Interest Coverage Ratio’ is one of the most crucial ratios used to assess the ability of companies to service their debt obligations. In this blog, we shall walk you through the meaning, importance, and interpretation of this ratio.
What is Interest Coverage Ratio?
An interest coverage ratio indicates how well a company can satisfy its interest (and other fixed-charge) obligations. It measures the extent of comfort that a company has in satisfying its interest payments from the surplus generated from its operations. This ratio is important because a company usually takes loans for strengthening its core business and, therefore, all commitments related to such loans must be met out of the returns generated from its main line of business. The interest coverage ratio checks whether a company can meet its interest commitments or not. It should be generating adequate income in order to satisfy its fixed obligations.
Did you know? ‘Interest coverage ratio’ is also known as the “times interest earned ratio”.
The formula for Interest Coverage Ratio (ICR)
ICR is computed using this formula:
In this formula, interest and finance charges show the interest paid by a company on all of its loans and borrowings. Commissions and bank charges paid by a company are also captured there.
For the computation of ICR, gross interest is taken into account instead of net interest. Net interest shows the interest expense of a company, net of any interest income received from investments made. The Gross finance charge is the interest payable as shown on the income statement.
Earnings before interest and taxes (EBIT) represent the profits made by a company from its several operations, prior to meeting its capital costs and taxes. It is also described as operating profit and is found on the income statement.
Earnings before interest and taxes (EBIT) are used in the numerator of this ratio because the ability to pay interest is unaffected by tax burden, meaning that interest cost is deducted from the total income before the imposition of tax. As interest on debt funds is a deductible expense, EBIT is taken in the numerator rather than earnings after tax.
Nature of output:
This ratio is expressed in ‘times’ (such as 4 times or 2 times) to indicate that profit is ___ number of times the interest expenses. It reveals the number of times interest is covered by the profits available with a business.
For example, if ABC Corp. has earnings before tax of $1,500,000 and interest payable on debentures is $150,000 for the current year, then ICR is $1,500,000 ÷ $150,000, which is 10 times. This means that ABC Corp.’s funds that are available for the payment of interest are 10 times the cost of interest.
As finance costs and operating profits fluctuate over time, so does the interest cover.
Let us take another example. Imagine XYZ Co is a listed company with 1 million $1 shares in issue and long-term bank borrowings of $5 million. The bank’s interest rate in the most recent year was 8%, but this is expected to change to 10% for the whole of the next year. The company made an operating profit of $1.84 million last year.
Interest cover for last year = $1.84 million ÷ ($5 million × 8%) = 4.60 times
Assuming that XYZ Co.’s operating profits remained constant in the next year,
Interest cover for next year = $1.84 million ÷ ($5 million × 10%) = 3.68 times
There is a decrease of 20% in interest cover from the last year, owing to an increase in interest costs.
What does it show?
The interest coverage ratio determines how many times a firm can cover its current interest payment with its available earnings. In other words, it represents the margin of safety that a company has for paying interest charges on its debt during a specific period.
This ratio is commonly used by lenders, investors, and creditors to assess a company’s riskiness in relation to its present debt or potential future borrowing.
While a single interest coverage ratio might disclose a great deal about a company’s current financial situation, looking at interest coverage ratios across years may often show a lot more about a company’s position and trajectory. Trends may emerge over time, providing a far better indication of whether a low current interest coverage ratio is improving or worsening, or whether a high current interest coverage ratio is constant.
Further, the ratio can also be used to assess or compare the ability of different entities to pay off their debts, which can aid in investment decisions.
Interpretation of Interest Coverage Ratio (ICR)
With a high interest coverage ratio, a company can easily satisfy its interest commitments even if earnings before interest and taxes suffer a significant decline. The business will still have enough profits to pay interest costs. In addition, a very high ratio also signifies that the company has been conservative in using debt to finance its operations.
On the other hand, a lower ratio implies inefficient operations or excessive usage of debt in financing business activities. Interest coverage is a combination of both the profitability of a company as well as its level of gearing. Variations in any of them will impact ICR. For instance, the interest coverage ratio would be low for entities that face problems in their manufacturing or other operations and, hence, experience a fall in their operating profits. Similarly, it would also be lower for companies that excessively rely on debt and outsiders’ funds to manage their business. For such companies, it might also be critical to see the proportion of debt and equity in their capital structure.
This ratio will have a direct relationship with the capacity of a company to employ debt financing. If the ratio is low, a company may be facing difficulties in paying interest on its existing debt and, therefore, should resist taking more loans. However, if the ratio is high, a company may use more debt financing easily as it has an ample amount of earnings available to meet the interest costs.
Another important point to note here is that it is quite possible that despite having a good ICR, a company’s cash flow position may remain weak. This could be because of non-cash revenue items such as appreciation in the value of a fixed asset arising out of revaluation, accrued but unrealized revenue, or others that may improve earnings without bringing in actual cash into the business. That is why ICR alone may not give an accurate insight into the capacity of a company to pay interest. It is equally important to analyze the cash flow position. (Source)
Moreover, as an alternative to the common formula for ICR shown above, sometimes lenders & investors use EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) rather than EBIT in the formula. Since EBITDA excludes non-operating expenses and certain non-cash expenses, it is considered to be a better approximation to the cash generated by a company (and available to pay interest with). EBITDA may be seen as a proxy for cash flow from business operations. (Source)
What is an ideal ratio?
The minimum value for a viable coverage ratio is 1.5 to 2. Below this number, lenders are likely to refuse to give a company more money, because the company’s risk for default may be considered as too high.
If the interest coverage ratio is less than 1, it indicates difficulty in fulfilling financial obligations by a company. In such a case, the company’s ability to pay interest is questionable. If a company’s ratio is less than one, it may be required to use some of its cash reserves in order to meet the interest expenses and may also risk falling into bankruptcy.
Because interest impacts a company’s profitability, it should only apply for a loan if it is confident that it will be able to manage its interest payments for years to come. (Source)
Takeaway
ICR is a reflection of a company’s ability to meet its repayment obligations in a timely manner. The higher the ratio, the more likely it is for a firm to service its debt commitments on time.
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