What is the importance of Interest Coverage Ratio?

"If there is one common theme to the vast range of the world’s financial crises, it is that excessive debt accumulation, whether by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom." — Carmen Reinhart

This quote perfectly depicts the companies that have huge debt on their balance sheet. When there is a bull run, and the stock is performing well, nobody bothers! You only get to know about the company's real strength during these tough times, and debt becomes a major component too! Because with debt comes the burden of interest.

In this article, we will be talking about a ratio that will help you to judge the company’s ability to pay its debt. So, stay glued! 

Interest Coverage Ratio (ICR)

 One of the significant and most crucial liquidity ratios is the Interest Coverage Ratio, which indicates the level of a company's ability to afford the interest that is to be paid by the company for raising debt. It does not measure the ability to make principal payments on the debt; instead, it depicts how much the company can promptly pay the debt's interest.

An investor shall be interested in the interest coverage ratio of a company as it determines whether the company can make timely payments without having to compromise on its day-to-day operations and profits that it is making. It also determines whether it is risky or profitable to invest in the company.

How to calculate the Interest Coverage Ratio?

Interest Coverage Ratio = Earnings before Interest & Tax (EBIT) / Interest Expense

To understand this better, let us consider the example of company ABC ltd, with its income statement:

Here:

• Earnings Before Interest & Tax/Operating Profit = Rs. 9,00,000

• Interest Expenses = Rs. 3,00,000

Interest Coverage Ratio
= EBIT/Interest Expenses
= 9,00,000/3,00,000
= 3:1

Hence, the company ABC ltd has an interest coverage ratio of 3, which indicates that it has sufficient funds to pay off the interests in a timely manner.

Factors affecting Interest Coverage Ratio

Some of the significant factors affecting the ratio mentioned above are:

• Gross Profit: The higher the company's total profit, the higher will be the operating profit, ceteris paribus. A higher operating profit will result in a higher interest coverage ratio.

• Operating Expenses: Lower the operating expenses, higher will be the operating profit, ceteris paribus, hence resulting in a higher interest coverage ratio.

• Interest Expenses: Lower the company's interest expenses, lower will be the denominator of the interest coverage ratio. This will indicate that the company has higher affordability of the interest expenses, hence resulting in a higher interest coverage ratio.

• Earnings before Interest & After Tax (EBIAT): This is a variation that some companies can use in place of EBIT. This will show a clearer picture of the company’s expenses before paying off the interest expenses, as taxes play a vital role in a company’s financial position. However, this will lower the interest coverage ratio.

• Earnings before Interest, Tax, Depreciation & Amortization (EBITDA): This is another variation that can be used in place of EBIT.

Interpretation of Interest Coverage Ratio

Some of the conclusions that can be inferred through analyzing the interest coverage ratio of the companies are:

• Solvency: Higher the interest coverage ratio, the more the company is solvent. It indicates that a lower portion of the company’s operating profit is dedicated to paying off its interest expenses, which means that the net income is more.

• Credibility: Higher interest coverage ratio means that the company is more solvent. High solvency implies that the company will be able to pay off the interests without any crunch. This increases the ability of the company to take on more credit. Lenders and creditors will believe more in lending money to the company who will promptly pay the interests. 

• A landmark for Small Companies: The higher the interest coverage ratio for a small company, the better it is. Sometimes the interest coverage ratio may even cross the mark of 5:1. This will indicate that although the company is operating on a small scale, it is making profits high enough to pay off the interest expenses and is not going towards bankruptcy.

• Interpretation for Large Companies: An interest coverage ratio of 2 to 2.5 may suffice for a large company. This is because the company is operating on a massive scale, due to which it has to take more and more credit which in turn means that it has to pay off more and more interest expenses. 

• Stability in Sales Revenue: If the company is operating in an industry where sales are relatively stable (such as the utility industry), the company can still stay solvent with a lower interest coverage ratio since the minimum revenue that the company will earn will be almost assured.

However, if the company is operating in an industry where the sales are relatively variable (such as the technology industry), the company needs to have a very high-interest coverage ratio so that it can pay off interests in a timely manner, even when the sales revenue are low.

Conclusion

The interpretations of the interest coverage ratio are dependent upon the industry or sector in which the company is operating. However, it can be safely surmised that an interest coverage ratio that goes below the mark of 1 can be dangerous for the company. Over some time, if such an interest coverage ratio is not improved, it may even lead to bankruptcy for the company.

So, ensure you take ICR into consideration while making your investment decisions.

Invest wisely!