What is Interest Coverage Ratio: Meaning, Formula & Example

The Interest Coverage Ratio (ICR) is the ratio that determines if a company can pay its interest costs from operating income. An important financial risk indicator, investors use it to evaluate a company’s financial status, credit risk, and capacity to meet interest obligations. This blog explains what the interest coverage ratio is, how to calculate it, and how to interpret it with practical examples.

Understanding Interest Coverage Ratio

The interest coverage ratio, also known as the 'times interest earned' ratio, shows how many times a company’s earnings before interest and taxes (EBIT) can cover its interest expense on outstanding debt. It also assesses the company's ability to pay interest on its debts and indicates the level of risk involved in lending money. A higher ratio suggests better financial health, whereas a lower ratio may denote trouble meeting interest obligations.

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Calculate Interest Coverage Ratio

The interest coverage ratio is calculated as:

Interest Coverage Ratio = Earnings Before Interest and Taxes/Interest Expense

Where:

• EBIT (Earnings Before Interest and Taxes) represents operating profit, showing how much income is available before paying interest and taxes.

• Interest Expense is the cost incurred for borrowed funds during the same period.

In some cases, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) is used instead of EBIT, particularly in industries with significant non-cash expenses. This is to provide a clearer picture of operational cash flow available for accumulated interest.

Let's delve into the calculation below with two interest coverage ratio examples.

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Calculating Interest Coverage Ratio Formula: Examples

1. Suppose a tech firm reports an EBIT of ₹60,000 and total interest expenses of ₹20,000. The interest coverage ratio is:

60,000 ÷ 20,000 = 3.0

This means the company earns three times its interest expense, indicating it can comfortably service its debt interest.

2. If a manufacturing company has an EBIT of ₹5,000,000 and interest expenses of ₹2,500,000, its ratio is:

50,00,000 ÷ 25,00,000 = 2.0

This indicates the company’s earnings cover interest payments twice over, generally considered satisfactory, but with less cushion than the first example.

Types of Interest Coverage Ratio

Interest coverage ratio has multiple variations, addressing different financial realities:

• EBIT Interest Coverage Ratio: Uses EBIT as the measure of how well the operating profits can cover the interest payments. This is the most commonly used and standard version, and expresses the company’s capability to bear the debt from its core operations.

• EBITDA Interest Coverage Ratio: Uses EBITDA by adding back non-cash expenses like depreciation and amortisation. This helps assess actual cash available to pay interest and is especially useful in capital-intensive sectors.

• Fixed Charge Coverage Ratio (FCCR): Includes other fixed financial obligations, such as lease payments, along with interest. It provides a better and wider picture of the company’s ability to meet its debt obligations.

• EBITDA Less Capex Interest Coverage Ratio: Subtracts capital expenditure from EBITDA to show cash left after essential investments. It helps in understanding whether the company is still able to pay interest after satisfying its regular Capex (Capital Expenditure) requirements.

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To Conclude

The interest coverage ratio directly evaluates a company's ability to pay interest on its debt using its operating earnings. A higher ratio, typically above 3, indicates strong financial health and lower default risk, while a ratio below 1 signals potential difficulty or distress. This metric is crucial for investors and creditors in assessing creditworthiness and financial stability.

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FAQs

What is considered a good interest coverage ratio for financial health?

Usually, a ratio above 3 is excellent, indicating a strong capacity to pay interest. A ratio in the 2-3 range is okay, while below 2 is a risk signal, and below 1 indicates severe financial distress.

How does the interest coverage ratio affect a company’s credit rating?

A higher interest coverage ratio usually results in higher credit ratings, indicating lower risk to lenders and investors. On the other hand, low ratios can have an opposite effect on creditworthiness.

What is a negative interest coverage ratio?

A negative interest coverage ratio means the company has negative EBIT and cannot cover its interest costs from operations. It signals severe financial stress and a high risk of default.

How do you calculate the debt-to-equity ratio?

The debt-to-equity ratio is found by dividing a company’s total liabilities by its total shareholders’ equity. It indicates how much debt the company uses compared to its own capital to finance its operations.

What distinguishes the interest coverage ratio from the debt service coverage ratio?

The interest coverage ratio measures how well a company can pay just the interest on its debt using operating earnings, while the debt service coverage ratio calculates its ability to cover both interest and principal payments. DSCR includes total debt obligations, providing a more comprehensive view of repayment capacity than ICR.