The interest coverage ratio is one of the basic ratios that indicate how much a company can pay their interest obligations on outstanding debts. If you happen to be an investor, lender, or entrepreneur, this one is among the most telling ratios for assessing the financial health and stability of a firm. The following article will discuss the meaning of the interest coverage ratio, how to determine it, and its significance.
The interest coverage ratio is a financial ratio that shows how able a company is to manage its outstanding debt.
The ratio is obtained by dividing a company’s EBIT by its interest expense. The lower more enormous the company’s debt and, therefore, the greater the risk of bankruptcy. A higher ratio suggests stronger financial health.
Key Takeaways
The interest coverage ratio indicates the company’s ability to cover its outstanding debt.
It can be expressed as the ratio of earnings before interest and taxes (EBIT) to the interest expense of the company.
ICR directly indicates that the higher the interest coverage ratio, the easier it is for the company to discharge its debts; too low ICR would mean that a company’s debt is more than its earnings.
Creditors use the ratio in deciding whether or not to lend money to a company.
A low ratio may not be attractive to some investors because it suggests the company is incapable of growth.
The interest coverage ratio is an important figure for creditors who wish to assess whether a company can pay back its debt. When it finds difficulty in doing so, future creditors would be reluctant to extend loans to the company.
Shareholders and investors will use the ratio in the same way to make decisions on their investments. A company unable to pay its interest liabilities risks increasing its existing debts and restraining access to other loans for expanding, research and development, or other investments.
Assessing Financial Health: Investors and creditors use the interest coverage ratio to evaluate a company’s ability to manage its debt obligations. A healthy ratio signifies that the company has enough earnings to reinvest in growth and handle debt payments.
Decision-making for Lenders: Banks and financial institutions often assess this ratio before approving loans. A low interest coverage ratio could lead to higher borrowing costs or loan denial.
Identifying Financial Risks: A declining interest coverage ratio over time might signal deteriorating financial health, prompting investors to reconsider their positions.
Comparing Companies: The ratio allows for easy comparison of financial stability among companies in the same industry, helping stakeholders make informed decisions.
The generic formula used to compute the interest coverage ratio is as follows:
Where:
EBIT stands for earnings before the accounting of interest and taxes, meaning operating profit.
Interest Expense: Is the total sum of interest a company is obligated to pay on its debts.
The interest coverage ratio is evaluated by dividing its earnings before interest and income tax by the total interest payment on the firm’s outstanding debts. The potential debt of a company generally consists of lines of credit, loans, and bonds.
For instance, a company will have an interest coverage ratio of 2.0 if earnings before taxes and interest equal $50,000 and total interest payments equal $25,000 (i.e., $50,000/$25,000 = 2).
A low-interest coverage ratio could mean that the company will not be able to service its debt; hence, the company will run a bigger risk of going bankrupt. A low-interest coverage ratio means that it has a small portion of profits available to cover interest payments on debt. If the company has variable-rate debt, the interest payments are likely increasingly burdensome in an expanding interest rate situation.
A high-interest coverage ratio indicates that sufficient profits are available to service the debt. However, it may also mean that the company does not employ its debt properly. For example, if a company is borrowing insufficient money, it will not be able to invest in the introduction of new products and new technologies to remain competitive in the long term.
A high ratio (>2): Generally, it indicates a good financial position, whereby the company earns more than twice its interest payable, suggesting good financial health.
A moderate ratio (1.5-2): A ratio in this arena means the company can meet its interest payments, but one small decline may cause some trouble for it to do so in the future.
A low ratio (<1.5): Ratios that are less than 1.5 are a cause for concern, indicating that interests may not get covered adequately, causing distress in going forward.
Good interest coverage may vary not only between various industries but also among companies within the same industry. Here are some thoughts regarding the ratio:
Some believe a company with solid and stable revenues should maintain an interest coverage ratio of at least 2.0.
According to some analysts, the industry dictates what coverage ratio is acceptable. A three or higher is preferred.
A coverage ratio below one means that some diagnostics need to be done regarding the company’s financial health.
There are several types of interest coverage ratios. Each has its purpose:
EBITDA Interest Coverage Ratio: A ratio of earnings before interest, taxes, depreciation, and amortization (EBITDA) over interest expense measures how many times a company’s cash would cover its interest expenses shortly.
EBITDA Less CapEx: This ratio measures how many times a company’s EBITDA would be available to cover future interest expenses after deducting capital expenditures (CapEx); it is expressed as (EBITDA – CapEx) – (Interest Expense).
Fixed Charge Coverage Ratio: This ratio tells how well the company services certain fixed expenses like rent or utility charges. It comes out as (EBIT + Fixed Charges)(Fixed Charges Before Taxes + Interest), but there are various variations of this depending on the field of business.
An ideal ratio would mean, hence, more satisfiable payment of financial obligations contained in the entity. But, again, that should not be construed as an unalterable rule, as such values are somewhat flexible.
Higher ratios are a plus for companies and industries that are sensitive to volatility, while lower ratios are acceptable for companies belonging to certain industries (like those that are heavily regulated). Thus, comparisons between companies should be discouraged if the companies do not belong to the same industry. For example, it would be meaningless to compare a public utility company (which generally has a low coverage ratio) with a retail company.
Despite being useful, the interest coverage ratio does come with certain limitations.
Ignores Cash Flow:
The ratio disregards actual cash flow in favor of EBIT, an accounting metric. Therefore, companies with high EBIT yet low cash flow may yet experience liquidity problems.
Variability by Industry:
The acceptable coverage ratios vary significantly among industries; e.g., capital-intensive industries may allow ratios lower than the ones allowed in technology companies.
Short-Term Dimension:
The ratio applies only to a particular point in time in respect of the financial position of the company, hence ignoring any long-term trends.
The interest coverage ratio is a financial ratio that measures the ability of companies to pay off their debts. In general, the higher the interest coverage ratio, the higher the chance that the company would be able to repay its interest obligations. Low ratios indicate high financial instability. Some analysts seek ratios at least above 2.0, while others prefer 3.0.
That will depend on the company as well as its industry. The variation would therefore differ differently from time to time, depending on the financing of new projects that have not yet generated returns. As such, it is looking at several aspects of a business instead of just one of them.
Profit Circulation: How much profit does the company generate per dollar of revenue? A higher margin answers just that: better operational efficiency.
Cash Flow Conversion: How well can the company convert its net profit into cash flow? This serves as a key measure of overall financial health and sustainability. – How to Analyze Stocks
This is a company with the following features:
EBIT = $500,000
Interest expense = $100,000
Thus, in this case, we can get:
With an interest coverage out of 5, this audit shows that for every dollar of interest to be covered in assets, the company earns five. This is a great sign of financial stability.
The interest coverage ratio can directly give you some insights into how well a company manages its debts. It can also be useful for assessing financial stability and comparing investment options. For instance, take the case of two companies and their interest coverage ratio over three years, as shown in the example below.
– | Year 1 | Year 2 | Year 3 | |
EBIT (Rs. lakh) | Company A | 10,000 | 15,000 | 20,000 |
Company B | 10,000 | 15,000 | 20,000 | |
Interest expenses (Rs. lakh) | Company A | 3,000 | 3,850 | 4,760 |
Company B | 3,500 | 8,100 | 11,500 | |
ICR | Company A | 3.33 | 3.90 | 4.20 |
Company B | 2.86 | 1.85 | 1.74 | |
From the table above, it is evident that for company A, the interest coverage ratio increases year after year, indicating growing financial stability. Company B, on the other hand, shows consistently declining interest coverage ratio because of its rising cost of debt.
Improve Revenue:
Increasing sales or revenue will directly increase EBIT, which in turn increases the ratio.
Cut Interest Costs:
Refinancing at a lower rate can help reduce interest expenses.
Reduce operational costs:
Streamlining operations and avoiding wastage help boost EBIT.
Repay Debt:
Repaying down a portion of the principal debt reduces the interest burden, thus helping the ratio.
The interest coverage ratio is an important marker for assessing the financial ability of a given company to service its debt. Despite the significant value the ratio brings, especially in relation to assessing leverage, it should be considered along with different financial measures and industry-specific benchmarks for a holistic perspective.
Through understanding and monitoring this ratio, investors, creditors, and owners will become better informed and make better decisions, leading to sustainability in business operations.
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Registered Office:
3-1-309/310, Tara Kaushalya Nivas,
Nimboliadda, Kachiguda, Hyderabad-500027
Contact: +916300169336
E-mail: admin@4rinvestments.in
Mumbai Office:
C/o.15B,5B, 1st Floor, Royal Industrial Estate,
Sewree Wadala Road No.26, Wadala(West),
Mumbai-400031
@2023 4R Investments. All right reserved.
Website by Vrinda Techapps
