Interest Coverage Ratio Definition, Formula & Example
Interest Coverage Ratio Definition – “An indicator of a company’s margin of safety on its interest costs – specifically, how many times over the company could make its interest payments out of current operating profits. To calculate interest coverage, divide EBIT by interest expense”.
It is one of the debt ratio that measures the firm’s ability to pay the interest on its debts on time. This ratio has no relation with the paying of the company’s debts. Instead it focus on the coverage of the interest on the debt taken.
Interest Coverage Ratio Formula
ICR = Earnings before Interests and Taxes/ Interest Expense
Interest Coverage Ratio Example
Let’s discuss an example in order to understand the interest coverage ratio definition in a better way. Kartik’s Sport Equipment Pvt. Ltd is expanding its business in various cities. So, it requires finances. For finances, they approach bank and bank asks for financial statement. The earnings before interest and taxes is Rs. 70,000. The interest and taxes are 25,000 and 10,000 respectively. Calculate ICR?
ICR = 70,000/25,000
This implies that Kartik’s company is making 2.8 times more earnings than the current interest payments. This indicates that the organisation is performing well and is operational efficient.
Importance of Interest Coverage Ratio
For creditors and investors, this ratio is very important. As investors wants that their investment grows in the organization. For that operation efficiency is very must. So investors monitors companies interest coverage ratio to see whether their company is paying the bills on time without compromising with the profits and operation efficiency.
On the other hand, creditors need to examine this ratio to see whether company is able to support additional borrowings. So, a company which is insufficient to pay the interest, then it will definitely fail in repaying the principal amount as well.
Interest Coverage Ratio <1, this indicates that companies earnings are not sufficient to repay the interest. So, forget about paying the principal amount. Such type of company is very risky to invest.
Now, if ICR = 1, this indicates that firm is making earnings just to cover up the interest payments. This situation is also similar to the previous one. As in this case also, company is incapable of paying principal amount of the debt. It only can pay the interest when it becomes due.
If ICR >1, this implies that company is making enough money in order to pay its interest payments. In addition this this, there are also additional earnings lefts for the payment of principal amount.
Ideal Interest Coverage Ratio
The ideal ICR is 1.5 times. Most creditors including banks look for ICR ratio above 1.5 times.