What is Interest Coverage Ratio?
Interest Coverage Ratio: How to calculate it and its significance
The financial or accounting ratio, which calculates whether a company is financially sound enough to pay interest on its debt on time, is termed the interest coverage ratio. This ratio should not be mixed with making principal payments on the debt or repaying the debt. It simply calculates the ability of a business to make timely payments of interest on a debt, servicing the debt.
Both investors and creditors use the interest coverage ratio to assess the company's profit and the risks it faces. To be able to implement the interest coverage ratio, you must learn and understand more about it and the way to calculate the interest coverage ratio.
How to Calculate Interest Coverage Ratio?
Here is the formula to calculate Interest Coverage Ratio:
Interest Coverage Ratio = EBIT / Interest Expense
EBIT = Earnings Before Interest & Taxes. A business’s operating profit (including depreciation and amortisation).
Interest Expense = Interest paid on borrowings such as bonds, lines of credit, loans, etc.
The formula for interest coverage ratio is widely used by investors, lenders, and creditors to measure business risk. It also helps determine the profitability of a company.
Interpretation of Interest Coverage Ratio
Higher Interest Coverage Ratio – If the interest coverage ratio of a company is 1, then it is considered to be efficient in servicing the debts with its earnings. In fact, a ratio of 1.5 is often considered good, though investors and analysts prefer this number to be 2 or and higher. Companies with historically unpredictable revenues are expected to have a 3 and above interest coverage ratio.
Lower Interest Coverage Ratio – An interest coverage ratio below 1 indicates that the company doesn't have sufficient revenue to service the existing debt. Anything less than 1.5 means that even though the business is currently servicing its interest obligations, its continuity is questionable. This uncertainty flares up if the company is vulnerable to cyclical or seasonal fluctuations in its revenue.
Variations of Interest Coverage Ratio
Besides the EBIT, there are two more variations. These are:
EBITDA — Earnings Before Interest, Taxes, Depreciation, and Amortisation
When calculating the interest coverage ratio, the EBITDA version uses profits before interest, taxes, depreciation, and amortisation. EBIT is often higher than EBITDA as depreciation and amortisation are excluded from the former. Since the interest expense stays the same for both in the formula, EBITDA calculation results in higher ICR than EBIT computation.
EBIAT - EBIAT stands for Earnings Before Interest and After Taxes
Unlike EBIT, EBIAT uses earnings before interest and taxes to calculate the interest coverage ratio. The tax liabilities from the numerator are deducted in EBIAT, making it a more suitable ratio to determine the ability of a firm to pay interest expenses. All tax liabilities are obligatory and mandatory. For most companies, tax liabilities are higher because of the tax structure, justifying the deduction. EBIAT also offers a clear view of a firm's capacity to pay interest costs.
Benefits of Interest Coverage Ratio
A company cannot be said to be inefficient and unstable if it is borrowing. This borrowing should be utilized competently to grow the business, build assets, acquire new projects, etc. Profitability is impacted by interest payments, and a business should be capable of handling these payments in a timely manner. The interest coverage ratio helps in understanding the actual ability and financial strength of a company to pay the interest on its debt.
Importance of Interest Coverage Ratio
The interest coverage ratio is significant in the ways mentioned below:
- Stakeholders in a company, such as investors, employees, and creditors, use this ratio to determine the stability of profit of a company. This allows them to make important decisions, especially when it comes to investing in it.
- The short-term financial health and stability of a company can also be determined using the interest coverage ratio.
- Lenders use this financial ratio to assess the creditworthiness of a business before allowing credit to them. Businesses with higher ICR are preferred by the lender.
- The interest coverage ratio also gives a clear picture of a company's stability in terms of interest on debt pay-outs or defaults.
- Regarding interest repayment, the trend analysis of the interest coverage ratio allows an apparent insight into the firm's stability.
With clarity on the different calculations of interest coverage ratio, it will now be easy to implement it to understand the stability of a given company.