Several financial measures, including the interest coverage ratio, serve as a solvency check for an organisation. Using it, businesses, investors, and financial analysts can easily decipher the current ability of a firm to pay off its accumulated interest on a debt. Notably, to use the same accurately, one must find out more than just the interest coverage ratio meaning.
What is the Interest Coverage Ratio?
It is a financial metric that comes in handy for ascertaining the number of times a company can pay off its interest with its current earnings before applicable taxes and interests are deducted.
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. This ratio is also known as ‘times interest earned’.
It must be noted that this particular ratio is not concerned with the repayment of the principal debt amount. The interest coverage ratio is entirely about a firm’s ability to settle interest on its debt.
How is Interest Coverage Ratio Calculated?
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 interest coverage ratio formula is used extensively by lenders, creditors and investors to gauge a specific firm’s risk when it comes to lending money to the same. It also helps to assess the profitability of the aforementioned company.
This ratio is given by –
Interest Coverage Ratio = Earnings before Interest and Taxes or EBIT/ Interest Expense
Interest Coverage Ratio = EBIT + Non-cash expenses / Interest Expense
Here, EBIT = A company’s operating profit
Interest expense = Interest paid on borrowings like loans, line of credit, bonds, etc.
Non-cash expenses = Depreciation and amortisation
Interest Coverage Ratio Example
Let’s compare the EBIT of two companies, namely – ABC Co and XYZ Co, with this ratio.
- Company EBIT
|ABC Co (EBIT)||9000||10000||12000||14000||15000|
|XYZ Co (EBIT)||9000||10000||12000||14000||15000|
- Company Interest
By using the formula –
ICR = EBIT/Interest
As per the outcome, it is determined that ABC Co has increased its ICR in the given period and remains stable throughout. On the other hand, XYZ Co shows a sharp decrease in its ICR, indicating problems related to liquidity and stability.
Analysis of Interest Coverage Ratio
Even though a higher interest coverage ratio is desirable, the ideal ratio tends to vary from one industry to another.
With that being said, let’s take a quick look at these pointers to analyse this financial metric –
- A ratio of less than 1 indicates that the firm is struggling to generate enough cash to repay its interest obligations.
- A ratio below 1.5 indicates the company may not be able to pay its interest on the debt.
- Low ratio signifies a higher debt burden and a greater possibility of default or bankruptcy. It also influences a company’s goodwill negatively.
- A ratio between 2.5 and 3 indicates that the firm will pay off its accumulated interest on debt with its current earnings. However, it may be an indicator of the firm’s internal policy or contractual requirement for maintaining a higher ratio.
Regardless, it must be noted that what would generally be accepted as a ‘good’ interest coverage ratio for some industries or sectors may not be potent enough for others. For instance, industries with stable sales like electricity, natural gas, etc. among other essential utility services tend to have a low-interest coverage ratio.
On the other hand, industries with fluctuating sales like technology, manufacturing, etc. manifest a higher IRC ratio. Consequently, the ‘good interest coverage ratio’ for both such sectors will be different. Nonetheless, it must be noted that a high EBIT may not be reliable proof of a high ICR.
Significance of Interest Coverage Ratio
These are among the prominent use of this ratio –
- A thorough analysis of the interest coverage ratio helps to avail a better idea about a firm’s stability when it comes to interest on debt pay-outs or defaults.
- It helps lenders to evaluate the creditworthiness of a company before extending credit to the company. They mostly prefer firms that have high ICR.
- Stakeholders like creditors, employees, investors, etc. use this ratio to gauge the profitability of the firm. In turn, it allows them to make timely decisions.
- It comes in handy to gauge a firm’s financial stability and financial health in the short-term.
- Trends analysis of this ratio offers valuable insight into a company’s stability when it comes to repaying interest.
However, individuals must become familiar with the shortcomings of this financial metric to make better use of it.
Limitations of Interest Coverage Ratio
Like other financial ratios, it isn’t easy to forecast a company’s long-term financial standing with an interest coverage ratio.
Other than that, these following points emphasise on the limitations of this ratio –
- It does not weigh in seasonal factors which are capable of distorting the ratio. As a result, it does not offer an accurate image of a firm’s financial standing.
- This ratio does not factor in the impact of Tax Expense on the cash flow of an organisation.
- Since the interest coverage for companies belonging to different industries is highly variable, it is not the best way to compare their performances or profitability.
- Companies may exclude or isolate certain debts while computing this ratio.
To analyse a firm’s financial statements, individuals should use 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. Furthermore, one should also weigh in other factors before investing in or lending capital to a particular company.