Interest coverage ratio, or ICR, is used to evaluate a company’s ability to pay the interest it owes on its debts. There is no generally agreed upon standard for what makes a healthy ICR across all industries. A higher value is generally better, however, and a value of less than 1 suggests a company may have difficulty meeting its interest obligations. Lenders and bond investors may be particularly interested in assessing companies’ ICR.
A financial advisor can help you create a financial plan for your investment needs and goals.
Calculating ICR
Calculating the ICR, which is also sometimes called the “times interest earned ratio,” requires two numbers, both of which are ordinarily available on a company’s income statement.
One of the numbers required to calculate ICR is earnings before interest and taxes, or EBIT. It is also sometimes called operating earnings or operating profit. EBIT can often be found on a company’s income statement. Or it can be calculated by subtracting cost of goods sold (COGS) and operating expenses from the company’s top-line revenue figure.
Interest expense will also be shown on a typical income statement. It may also be labeled as financing costs.
Once these two numbers are obtained, the formula for ICR looks like this:
ICR = EBIT / Interest expense
For example, if a company has $550,000 in EBIT and interest expense of $50,000, the formula would look like this:
$550,000 / $50,000 = 11.
In this case, the company’s ICR is 11. An ICR of 11 is generally a sign of a company that will have no difficulty paying interest on its debts from profits generated by operations.
In the case of another company with EBIT of $250,000 and interest expense of $175,000, the ICR formula would look like this:
$250,000 / $175,000 = 1.4
This significantly lower ICR still indicates the company can pay its interest obligations from operating earnings. In some industries, this ICR may be seen as excessively risky, however.
Interpreting ICR
Lenders may use a company’s ICR when deciding whether to approve a loan request. The ICR may also play a role in determining the cost of a loan. A company with a lower ICR may be seen as riskier and have to pay more interest on its borrowings. Bondholders and investment analysts also examine ICR to see whether a company is likely to be able to continue making the interest payments on its bonds.
While an ICR below 1 suggests a company may not be generating sufficient operating profits to pay the interest it owes on its debts, a higher number may not always indicate good financial health. Different industries have different benchmark ICRs. Analysts also often examine whether a company’s ICR is getting higher or lower over time. A company with a declining ICR may be headed toward bankruptcy.
Limits of ICR
While ICR is useful and widely used, it isn’t the last word on business creditworthiness. For one thing, it only looks at interest payments. ICR doesn’t necessarily tell a lender or investor anything about a business’s ability to pay back the principal amounts it has borrowed. Also, the numbers used to compute it may not always be good indicators. For example, some borrowers may have the ability to defer interest payments on loans to a subsequent year. If that is the case, the ICR may overstate the ability of the business to make good on its interest obligations going forward because the financial expense has been understated.
Business analysts also use other financial metrics related to debt when examining businesses. The debt-service ratio, for instance, looks at debt payments that are due within one year. The debt-to-assets ratio reports the percentage of a business’s assets that have been financed with debt. The fixed charges coverage ratio also includes insurance, rent and other expense commitments.
Bottom Line
ICR is a financial ratio used by lenders, creditors and bond investors to evaluate a company’s ability to pay its interest obligations using income generated from operations. It is calculated by dividing interest payments into operating income. ICR should usually be more than 1 and a higher number is generally better. The way ICR is trending can be an indicator of whether a company’s financial condition is deteriorating or improving.
Tips for Evaluating Business Operations
- Consider working with an experienced financial advisor who can help you interpret the ICR of a company you’re looking at as a possible investment. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- While income statements are important for gauging ICR, it’s also important to understand how to interpret a company’s balance sheet. It’s a document that businesses can use to summarize their company’s financials, and which investors can then use to determine the value of a company.
Photo credit: ©iStock.com/Zerbor, ©iStock.com/AndreyPopov, ©iStock.com/SARINYAPINNGAM