Interest Coverage Ratio for companies
Almost all businesses set their revenue and sales targets periodically and make an effort to meet these targets. They will also try to reduce their expenses to maximize their earnings. One of the factors which are used for setting the target is the debt which the company has, and the interest which has to be repaid monthly. A business can survive in the long term, only if it is earning enough to repay the interest and other expenses easily. Thus the ratio of the companies earnings and the interest payments are also closely monitored by the investors and lenders to determine the financial health of the company.
The Interest Coverage Ratio abbreviated as ICR is the ratio of the earnings of a company before interest and taxes (abbreviated at EBIT) and the total interest expenses. Most companies are borrowing money for capital investment and other reasons. The business will flourish only if the company has enough revenues to repay the interest on the loan and other expenses. If the ICR of business is low it implies that the business is facing a problem or there is a problem with the business model and it may be necessary to review the business.
Interest Coverage Ratio Formula
The basic formula for calculating ICR is as follows
ICR = EBIT /Interest expenses
In some cases, the interest expenses may be replaced by finance costs, in the comprehensive statement of income. There are other ways of calculating the ICR. In some cases, the earnings before depreciation, amortization, interest, taxes(EBITDA) may be considered instead of EBIT. When the EBITDA is used, the ICR calculated is usually higher in value compared to the EBIT ICR calculation. Another variation considers the Earnings before interest and after taxes (EBIAT) instead of EBIT for ICR calculation. In this case, the ICR is usually lower than the BIT ICR
Interest coverage ratio calculator
Interest Coverage Ratio Explanation
The ICR is calculated for a specific time period, which may be one month, quarterly, annually, depending on the business. The parameter is closely monitored by the company, especially the finance department if the company has a lot of debt so that they can try to improve it, either by increasing the revenues or reducing the expenses. Additionally, it is also used by lenders to check the financial condition of the company. Like other investors, the lenders would like to be reasonably assured that the borrowers have enough income to repay the interest and principal on schedule and the ICR is one parameter used to check the financial condition.
High debt companies
The ICR of a company will vary depending on its financial condition, size, and industry sector. Usually, if the ICR is low at 1.5, it means that the company is facing a financial crisis, and is unable to make enough money to repay the debt. If the ICR ratio is below 1.5, most lenders will refuse to lend money to the company since the risk of default is very high. A company with an ICR of less than one is not generating enough income, to repay the interest expenses. In the short term, the business will have to use some of its cash reserves to repay interest. If the ICR does not improve in the long term, the business will have to shut down.
Limitations of Interest Coverage Ratio
Like other ratios, there are some limitations to using the ICR, and the investor or analyst should be aware of these variations. The acceptable ICR varies greatly depending on the industry sector. Utility companies have high earnings, since there is less competition, yet they also have high debt, so the acceptable ICR is approximately two. On the other hand, for manufacturing companies, three is the typical ICR for most companies. Some companies may have high ICR, however, this could indicate that the company is very conservative, and is missing out on opportunities available.
In addition to calculating the ICR at a specific time, investors and lenders should also consider the variation of the ICR over a period of time. If the ICR of the company is declining over a period of time, it means that the company could be facing a financial crisis. On the other hand, if the ICR is improving, it indicates an improvement in financial health. It should be noted that the ICR may reduce drastically due to an unexpected event like a strike or recession when the sales or production will decline significantly. Large well-established companies often have low ICR.