A company’s debt position can be gauged using the interest coverage ratio or ICR. This financial measure is used by lenders and the company stakeholders to gauge the company’s ability to make interest payments on outstanding debt. Investors also use this ratio before buying stocks of a company.
Here, we will explain the interest coverage ratio in detail, along with its calculation and usage.
Meaning of interest coverage ratio
Any company that borrows debt has to pay interest towards debt servicing.
Interest coverage ratio is:
- the number of times that a company can make interest payment
- based on earnings before interest and taxes or EBIT
- also represented as – EBIT / interest expenses (EBIT).
- an indication of a company’s existing debt and its ability to pay interest on the same
EBIT is also called a company’s operating profit.
Let’s take an example to understand the concept of Interest Coverage Ratio:
Company X has following revenues and expenses for the last quarter:
- Revenues = Rs. 10,00,000
- Cost of goods sold = Rs. 1,50,000
- Operating expenses = Rs. 50,000
- Earnings = Revenues less cost of goods sold less operating expenses = Rs. 8,00,000
- Interest payment on debt = Rs. 50,000 per month
Interest Coverage Ratio can be computed by converting the monthly interest payment to quarterly:
Interest payment for the quarter will be = Rs. 50,000×3 = Rs. 1,50,000
ICR = Rs 8,00,000/Rs 1,50,000 = 5.33.
This indicates that the company’s earnings are sufficient to make interest payments 5.33 times.
Interpreting interest coverage ratio
- If ICR is below 1 – it means the company may be having a higher debt burden and there are chances of default or bankruptcy. A Lower ICR ratio can be interpreted as the company’s earnings being too low and may have to bear the burden of a higher interest rate.
- If ICR is below 1.5 – it means the company’s position is hindering its chances of securing additional credit from lenders.
- If ICR is above 1.5 – it means the company has sustainable earnings. A higher ratio indicates that the company’s financial health is good, and it is not taking additional risks by using leverage to magnify its earnings.
How is it used by stakeholders?
By analysing ICR, lenders can assess the borrowing company’s credibility and its capability to service the debt. Many banks and lenders generally have ICR as part of their due diligence for loans.
- Investors can use ICR to gauge the security of their investment in the company. It tells investors whether the company is capable of managing and servicing the extra debt, that is interest payments.
- Creditors use ICR to check a company’s financial health.
- Lenders and bankers use it for determining the company’s creditworthiness.
How is interest coverage rate helpful?
Borrowing funds can work in a company’s favour if used smartly towards building assets and attaining growth. Since interest payments can have a significant impact on a company’s profitability, it should assess beforehand whether it can handle these payments in a consistent manner. ICR can act as a metric to know if the company is capable of managing its borrowings.
- If the interest coverage ratio is interpreted in detail, creditors, lenders, investors, etc. can get a better idea about the risk involved in lending to a company and its stability as far as debt servicing is concerned.
- It is also helpful for investors in assessing the company’s investment-worthiness as it tells whether the company is financially stable.
Types of interest coverage ratio
Here are the different types of interest coverage ratio:
- Times interest earned (TIE) ratio: measures a company’s ability to cover its interest payments by comparing its EBIT to its interest expenses.
- Debt-service coverage ratio (DSCR): measures a company’s ability to meet its debt obligations, including principal and interest payments.
- Fixed charge coverage ratio (FCCR): measures a company’s ability to meet its fixed obligations, such as lease payments, in addition to interest expenses.
- Cash flow to debt ratio: measures a company’s ability to generate enough cash flow to cover its debt obligations.
- Interest coverage ratio for banks: measures a bank’s ability to cover its interest expenses by comparing its net interest income to its interest expenses.
Importance of the interest coverage ratio
The interest coverage ratio is an important financial metric used to assess a company’s ability to pay its interest expenses. Here are some reasons why it’s important:
- Helps investors and creditors evaluate a company’s creditworthiness and financial health.
- Provides insight into a company’s ability to generate earnings and cash flow to cover its interest payments.
- Helps investors and analysts compare a company’s financial health to its peers and industry standards.
- Can signal potential risks, such as high levels of debt or low earnings, that could affect a company’s ability to meet its interest obligations.
- Can be used by companies themselves to evaluate their own financial health and identify areas for improvement.
Factors to note before using interest coverage ratio
ICR, just like any other metric, has its own limitations despite being one of the most widely used ratios. Here are some factors to note about ICR:
- ICR can vary across industries. Also, a different ratio is considered acceptable in different industries.
- While comparing ICR, one must ensure to consider only those companies that operate within the same industry, conditions and with similar business models.
To sustain in a constantly changing demand scenario that is highly affected by frequent lockdowns and supply restrictions, Indian companies are said to have changed their focus towards improving debt servicing ability by using cost rationalisation and controlling long-term debt. As per a survey conducted on a sample size of about 1,900 companies, the Interest Coverage Ratio is said to have improved to 4.9% in Q2′ 21 from 1.8% in the previous year’s quarter.
Interest coverage ratio is one of the many metrics that are used for analysing a company’s financial health. An ICR above 2 or 3 is preferable and if it’s below 1, it is a negative sign. ICR is commonly used by creditors, lenders, investors and analysts to assess a company’s financial status. ICR is best used in combination with other metrics like quick ratio, debt-to-equity ratio, current ratio, etc. This way, any drawbacks of ICR can be covered while effectively assessing a company’s financial health.
Capital intensive companies may have higher debt and therefore lower interest coverage ratio. Banks too tend to have a low interest coverage ratio owing to their core business of lending. Rise in interest rates and high operating leverage are some of the other factors that contribute to a low interest coverage ratio.
Debt to equity ratio is used to know how much debt a company has for every rupee of equity it holds. It does not tell us about the company’s ability to repay the debt. Interest coverage ratio, however, tells us whether the company can pay interest on its borrowings. These two ratios have an inverse relationship.
EBITDA is short for earnings before interest, taxes, depreciation, and amortization. It is used as a metric to check a company’s overall financial performance. EBITDA is also used as an alternative to measuring net income.
Financial ratios use numerical values from a company’s financial statements. These help in offering meaningful insight into a company and its performance. Some of the figures found on a company’s financial statements are commonly used to conduct a quantitative analysis for assessing a company’s liquidity, profitability, leverage, growth, rates of return, valuation, etc.
The cost of debt is often lower than the cost of equity because the latter only involves interest cost. However, in case of equity, the returns to be given to shareholders often come with a risk premium.