What Is an Interest Coverage Ratio?

Introduction

Interest coverage ratio is a tool used to measure a company's ability to cover its total interest expenses with its available earnings. It is important because it serves as a warning signal to potential creditors, investors, and lenders that a company may not be able to meet its obligations.

The interest coverage ratio (ICR) is calculated by dividing a company's earnings before interest and taxes (EBIT) by its total interest expenses. The higher the ratio, the easier it is for the company to fulfill its debt obligations. Generally, a ratio of at least 2.5 is viewed as healthy.

Calculation

Determining an interest coverage ratio requires the use of a formula. For the purposes of this post, the formula is calculated by dividing income before interest and taxes (EBIT) by the interest expense reported on the income statement. To calculate the ratio, the following inputs are required.

Formula

The formula to calculate an interest coverage ratio is:

Required Inputs

• Income before interest and taxes (EBIT)
• Interest expense reported on the income statement

EBIT is the total amount of money a company has earned, before taking into account any taxes or interest payments. The interest expense is derived from the income statement. It is the amount of money a company has to pay to borrow funds.

Types of Interest Coverage Ratios

Interest coverage ratio is a financial indicator of a company’s ability to meet its debt service payments such as interest payments on bonds. The interest coverage ratio helps to determine how easily a company can pay its interest expenses. In this article, we will look at the two most popular types of interest coverage ratios—fixed charge coverage and times interest earned.

Fixed Charge Coverage

The fixed charge coverage ratio measures the ability of a company to pay interest as well as other fixed charges that must be paid. Examples include leasing payments and insurance premiums. The formula for the fixed charge coverage ratio is:

• Fixed Charge Coverage = (Earnings Before Interest and Taxes + Fixed Charges) ÷ Fixed Charges

The fixed charge coverage ratio is generally used to determine if a company has enough money to pay its fixed charges in addition to its interest payments. Higher fixed charge coverage ratios indicate that the company has sufficient funds to meet its obligations.

Times Interest Earned

The times interest earned ratio measures the ability of a company to pay interest expenses on its debt. The formula for the times interest earned ratio is:

• Times Interest Earned = Earnings Before Interest and Taxes ÷ Interest Expense

The times interest earned ratio is an indication of a company’s financial stability and is an important measure of solvency. A higher times interest earned ratio indicates that the company is able to easily make its interest payments.

Impact of Financial Leverage

The Interest Coverage Ratio (ICR) is an important financial ratio used to measure a company’s ability to pay its interest expenses on any debt outstanding, such as loans and bonds. The ratio helps investors to understand how leveraged a company is and understand the associated risks based on the figure.

High vs. Low Leverage

ICR is always measured as the ratio of financial performance to interest payments. A high Interest Coverage Ratio indicates low financial leverage and indicates that the company has enough cash flow to easily cover its financial obligations. A low Interest Coverage ratio indicates a higher financial leverage, which means the company is highly leveraged and does not have enough cash flow to cover its interests.

Benefits and Risks

As a general rule, the higher the ICR, the better, as it means the company has more ability to make interest payments than it has to use them. In addition, companies with high ICRs have more stability as they can invest in new ventures and finance disruptions and are able to expand in the long run. On the other hand, companies with low ICRs are more likely to be affected by a financial disruption and find it difficult to finance new projects.

• Benefits of High Leverage:
  • More cash flow available to cover debt obligations
  • More stability to finance new ventures
  • More ability to expand in the long run
  
  
• Risks of Low Leverage:
  • Highly leveraged companies more vulnerable to financial disruption
  • Difficulty in financing new projects
  
  

Evaluation

One of the best ways to evaluate an interest coverage ratio is to compare it to both the industry average and the company’s own historical performance. Analyzing rations across industries is essential, as different industries have different capital structures and debt management strategies. Understanding the differences can provide insight into a company’s level of risk.

Examples of Good vs. Poor Ratios

A good ratio indicates a company is making sufficient profits to meet its periodic interest obligations. Generally, a ratio of 2.0 or higher is considered a healthy interest coverage ratio. Ratios lower than 1.5 should raise a red flag and warrant further research on the company’s financial condition. For example, a company with a ratio of 0.5 may have difficulty paying back its loans and could be at risk of defaulting.

Industry Analysis

In order to make an accurate evaluation, comparison of the interest coverage ratio should be made with similar companies in the industry. Typically the industry average of the interest coverage ratio will be higher than the median individual company ratio. If the average ratio of all companies in the industry is 3 and the target company’s interest coverage ratio is 1, then the investors should be consider the investment risks associated with investing in the company.

To make an accurate assessment of the company, it is necessary to consider the quality of earnings, the level of debt of the company and the sector-specific risks and dynamics. With a comprehensive analysis, investors are in the best position to make an informed decision about the company's investment prospects.

Uses of Interest Coverage Ratios

The interest coverage ratio is a financial ratio that can be used in a variety of different ways. It provides important insight into a company's ability to meet its interest expense obligations and is often used by banks and investors to determine how secure a loan or investment is.

Banks

Banks use interest coverage ratios to assess the ability of a company to repay its debt. Banks not only look at the company’s present level of the ratio upfront, but will also look to see if there is a track record that a company has been able to consistently meet its interest obligation. If the ratio falls below an acceptable level after a loan is extended, a bank is likely to require the borrower to increase their principal payments in order to restore the ratio.

Investors

Investors also use the interest coverage ratio to help decide whether or not to invest in a company. Opportunistic investors look for companies whose ratios are lower than the industry standard, as this could indicate that the company is a good opportunity for investment. On the other hand, investors may also be uncomfortable investing in a company where the ratios indicates it’s in a vulnerable position.

In addition, the ratio can be used to compare potential investments and to identify the level of risk associated with each. By comparing the ratio of different potential investments, an investor can make a more informed decision on which one provides the most value and is least risky.

Conclusion

An interest coverage ratio is a key indicator used to determine a company's ability to meet its debt obligations. It is calculated by dividing a company's earnings before interest and taxes (EBIT) by its total interest payments. A higher ratio indicates a greater level of coverage, which may be viewed by lenders as a sign of financial health. The ideal interest coverage ratio is greater than 2 to 1, though this number may vary depending on the industry or the lender.

Summary

In summary, an interest coverage ratio is a useful financial measure used to evaluate a company's ability to meet its debt-related obligations. It is calculated by dividing a company's earnings before interest and taxes by its total interest payments. A higher ratio usually indicates a stronger ability to repay debt obligations and is generally viewed positively by lenders. It is important to note that the ideal ratio may differ depending on the industry or lender.

Final Thoughts

Understanding interest coverage ratios is important for business owners and lenders alike. A healthy ratio may indicate that a company has a good chance of being able to make its debt payments in a timely manner. It is always important to do further research in order to ensure that a company can meet its financial obligations in the long run.