What is Interest Coverage Ratio? Definition, Formula & Interpretation

Trading concepts

Interest Coverage Ratio

What is Interest Coverage Ratio?

Interest coverage ratio also known as times interest earned ratio evaluates the ability of an organization to take care of its outstanding debt.

It is a type of debt ratio traders and investors use to measure the financial condition of an organization.

Both market analysts and traders deem the interest coverage ratio to be vital because the growth of an organization is dependent on it. 

Also, an organization must be able to pay the interest on its existing dues to creditors to survive.

The term ‚Äúcoverage‚ÄĚ denotes the duration of time. Meaning the number of fiscal years in which the investor can make interest payments using the recent available income of the organization.

It represents the number of periods an organization can pay its dues with its income.

An organization with huge current income surpassing the amount needed to make interest payments for its debt has a bigger financial cushion against an ephemeral downturn in revenues.

Furthermore, an organization that is hardly able to fulfill its interest dues with its current income is in a really dangerous financial state.

And as such, a little temporal decline in revenue can usher it into bankruptcy.

Formula for the Interest Coverage Ratio

You can calculate the interest coverage ratio by diving earnings before interest and taxes (EBIT) by the total amount of interest expense on the organization’s debts.

The debt of an organization entails bonds, loans, and credits.

ICR = EBIT / Interest Expense

Definition of terms:

ICR (Interest Coverage Ratio)

EBIT (Earnings Before Interest and Taxes)

Example: If ABC company’s earnings before taxes and interest equate to $40,000. And its total interest payment requirements amount to $10,000.

The interest coverage ratio would be four.

$40,000/$10,000 = 4

Note: You can use this formula to calculate the ratio interest period ranging from annually to monthly.

Interpreting the Interest Coverage Ratio

If an organization’s interest coverage ratio is low. The probability of such an organization not being able to meet up with its debt payment is high.

Simply, a low ICR denotes that the amount of profits available is low and not enough to pay the interest expense on the due.

Again, if the organization has variable rate debt. There will be an increase in the interest expense in a rising interest rate area.

The lesser the ratio, the more the organization gets into debt expenses and the lower the capital it has to make use of in other areas.

If an organization has only a 1.5 or the lesser coverage ratio. Its chances of making up for interest expenses may be unrealistic.

It is a must for organizations to possess more than enough income if they intend to be able to cover interest payments to surviving in the future. And probable sudden monetary difficulties that may come up.

An organization’s capability to live up to its interest expectations is a part of its solvency and is a vital factor in the return for shareholders.

Importance of the Interest Coverage Ratio

Meeting up with interest payments is an essential and continuous concern for any company. Immediately an organization begins to struggle with its dues. It might have to keep borrowing or find itself dipping into its money reserve. Also you can best use this for capital assets investment or sudden emergencies.

While focusing on a single interest, coverage ratio may present a good deal concerning an organization’s current financial stance. Assessing interest coverage ratios after some time usually provides a much vivid picture of an organization’s stance and path.

Observing an organization’s interest coverage ratios quarterly, for around five years ago. This will give an investor the knowledge of whether there is an improvement, decline, or stagnation with the ratio. And gives a great analysis of an organization’s short-term financial status.

The desirability of any level of this ratio lies in the hand of the owner to a certain degree.

Buyers of the prospective bonds may not be bothered with a less desirable ratio in exchange for levying the organization a huge interest rate on their dues.

As a result, most people see an interest coverage ratio of 1.5 as a minimum acceptable ratio for an organization. Snd the tipping point lower which borrowers will possibly decline to borrow the organization’s additional fund. And this is because the organization’s risk for owing is too enormous.

In a situation where the interest ratio of a company is beneath one. It will possibly be required to use some of its reserve money to meet the difference. Or better still, you can borrow more.

And this, of course, would be problematic making the result not to be palatable. And if the organization realizes a low income for a single month, such an organization risks running into bankruptcy.

Limitations of the Interest Cover Ratio

As with any metric trying to measure the performance of a business; the interest coverage ratio can be connected to some series of limitations that are crucial. And it should be considered before use by any investor.

  • Firstly, it is vital to note that interest coverage varies massively when measuring organization in diverse industries as well as when measuring organizations with the same industry. In the case of an established organization in a specific industry; such as utility organization, the acceptable standard is usually an interest coverage of two.
  • A well-established utility will possibly possess regular production and revenue, mainly because of government policies, so even with a somewhat low-interest coverage ratio. It might reliably be capable of covering its interest obligations.

Other industries, like those producing, are much more volatile and may usually possess a higher acceptable standard coverage ratio of three or higher.

This variation of companies usually experiences larger fluctuations in business.

For instance, during the 2008 recession, the sales of cars fell substantially, affecting the auto manufacturing companies. Another example is workers’ strikes of a sudden event that may affect the interest coverage ratio.

Since these industries are more likely to experience fluctuations. It is advisable to depend on greater ability to cover their interest to make up for low earning periods.

Due to these wide variations across industries, the ratio of a company ought to be assessed to others in the same industry and preferably those with similar business models and revenue figures.

Additionally, even though it is crucial to take into consideration all debts when calculating the interest coverage ratio, organizations may decide to keep aside or eliminate certain types of debt in the calculations of their ICR.

What is a Good Interest Coverage Ratio?

A ratio beyond one shows that a company can cover the interest on its debts making use of its earnings, or has displayed the capability to keep revenues at a reasonably consistent level.

While an interest coverage ratio of 1.5 is the minimum acceptable standard, analysts and investors prefer two or more.

And as for organizations with more volatile revenues, the preferable interest coverage ratio would be above three.

What Does a Bad Interest Coverage Ratio Shows?

We regard any number or value below one as a bad ICR as this implies that the organization’s current income is not enough to cover their outstanding debt.

The probability of such an organization meeting its interest expenses going forward is questionable even with a below 1.5 interest coverage ratio. It gets worse if the organization is prone to seasonal dips in revenue

Russell Crane

Russell Crane

Russell is an Algorithmic & Technical Analyst Trader @ PatternsWizard.
His passion is to share his knowledge about TA, patterns & more. Why hope for your trading to work when you can precisely know the performance stat of every pattern?

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