The interest coverage ratio?
The interest coverage ratio measures a company’s capacity to pay interest on its outstanding debt. To get a company’s interest coverage ratio, divide its EBIT by its interest expense for a particular period.
The interest coverage ratio is the time’s interest earned (TIE) ratio. Lenders, investors, and creditors use this formula to assess a company’s riskiness for present or future debt.
Formula for Interest Coverage Ratio
The interest coverage ratio’s “coverage” is the number of quarters or fiscal years the company’s earnings can cover interest payments. Simply put, it indicates how often the company can meet its obligations using earnings.
The formula is:
The interest coverage ratio is equal to EBIT minus interest expense. EBIT = Earnings before interest and taxes Coverage Ratio = Interest ExpenseEBITwhere: EBIT is earnings before interest and taxes.
Lower ratios mean more debt expenses and less capital for other uses. If a company’s interest coverage ratio is 1.5 or less, it may struggle to pay interest.
Companies must have enough earnings to cover interest payments to survive future and possibly unanticipated financial challenges. A company’s ability to satisfy interest obligations is crucial for its solvency and shareholder return.
Interpreting Interest Coverage Ratio
Any corporation must constantly manage interest payments. When a corporation faces obligations, it may need to borrow or spend its cash reserve, which could be better utilized for capital asset investments or emergencies.
Analyzing interest coverage ratios over time might better reveal a company’s financial situation and trajectory than looking at one ratio.
Quarterly interest coverage ratios for a company’s last five years can help investors assess its short-term financial health by showing whether the ratio is rising, falling, or stable.
The desirability of any ratio level is subjective. Banks or bond buyers may accept a lower ratio for a higher debt interest rate.
Example of Interest Coverage Ratio
Suppose a corporation earns $625,000 each quarter and has obligations that require monthly payments of $30,000. To calculate the ICR, multiply monthly interest payments by three (for the remainder of the calendar year). Company ICR: $625,000 / $90,000 ($30,000 x 3) = 6.94. This suggests the corporation has no cash issues.
A corporation’s minimum acceptable interest coverage ratio is 1.5, below which lenders may refuse to lend more money due to perceived high default risk.
A corporation with a ratio below one will either need to spend part of its cash reserves or borrow more, which is challenging for the reasons above. Even a month of low earnings can lead to insolvency for the company.
Interest Coverage Ratio Types
Before reviewing company ratios, consider two frequent interest coverage ratio variants. Variations are due to EBIT changes.
EBITDA
Sometimes, the interest coverage ratio is calculated using EBITDA instead of EBIT. Due to excluding depreciation and amortization, EBITDA calculations typically provide bigger numerators than EBIT calculations. EBITDA has a better ICR than EBITDA because the interest expense is the same.
EBIAT
Another method calculates the ICR using EBIAT instead of EBIT. Tax charges are deducted from the numerator to better reflect a company’s ability to pay interest. EBIT might be used instead of EBIT to assess a company’s ability to cover interest expenses, as taxes are a crucial financial factor.
Limits on Interest Coverage Ratio
Like every company efficiency statistic, the interest coverage ratio has limits that investors should consider before employing it.
First, interest coverage varies significantly among businesses and even within industries. An ICR of two is typical for established utility firms.
Even with a low ICR, a well-established utility may be able to repay its interest payments due to government rules and continuous output and revenue. Manufacturing is more volatile and may require a minimum ICR of three.
These firms experience more business fluctuations. Car sales plummeted during the 2008 crisis, affecting automakers.1A workers’ strike is another unexpected occurrence that could lower interest coverage rates. Because these industries are more volatile, they must be able to cover their interest during low earnings.
Due to industry-wide differences, companies’ ratios should be compared to others in the same industry, ideally with similar business structures and revenue levels.
While all debt should be considered when determining the ICR, corporations may isolate or exclude particular types of debt. Check a company’s self-published ICR to see if all debts are included.
What Does the ICR Tell You?
The ICR assesses a company’s debt management. It is one of several debt ratios used to assess a company’s finances. The term “coverage” refers to the number of years (often fiscal years) the corporation can pay interest on its existing earnings. It shows how often the corporation can pay its debts with earnings.
Interest Coverage Ratio Calculation: How?
EBIT is divided by interest on debt expenses (the cost of borrowed money) to produce the ratio, often annually.
A Good Interest Coverage Ratio?
A ratio above one shows that a corporation can service its obligations with earnings or maintain steady sales. Although 1.5 is the least acceptable ICR, analysts and investors prefer two or more significant. Companies with historically fluctuating sales may not have a good ICR unless it exceeds three.
The bad interest coverage ratio indicates what?
A lousy ICR below one indicates that the company’s earnings are insufficient to satisfy its debt. Even with anICR below 1.5, a company may struggle to fulfill its recurring interest expenses, especially if it is susceptible to seasonal or cyclical revenue fluctuations.
Conclusion
- The ICR measures a company’s ability to pay debt interest.
- Divide a company’s EBIT by its interest expense to calculate its ICR.
- Some formulas calculate the ratio using EBITDA or EBIAT instead of EBIT.
- An extensive coverage ratio is better, but industry-specific ratios may be better.
