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Debt is one of the major sources of financing for many companies. Even though debt financing enables a company to grow, it entails a financial commitment in the form of payment of interest. This is where the Interest Coverage Ratio (ICR) becomes useful.
The Interest Coverage Ratio allows investors to determine how comfortably a company can service its interest payments using its operating income.
For instance, a company with an ICR of 5 implies that its operating income is five times its interest expense. It is especially helpful when comparing companies with different amounts of debt.
This article explains everything you need to know about the interest coverage ratio, including its benefits, limitations, among others.
Key Takeaways
- Interest Coverage Ratio measures a company's ability to pay interest on its debt.
- A higher ICR generally indicates better interest-paying capacity.
- A low ICR can be a warning sign of financial stress.
- An ICR below 1 means the company's operating earnings are not enough to cover its interest expense.
- ICR should be compared with previous years and with companies in the same industry.
What is the Interest Coverage Ratio?
The Interest Coverage Ratio is a financial ratio that shows how easily a company can make payments of interest on its debt. In simple words, it answers one basic question:
How many times can the company pay its interest expense using its operating earnings?
Assuming that a company earns ₹10 crore as EBIT and spends ₹2 crore as interest. The interest coverage ratio will be 5 times. It implies that the operating earnings of the company are five times the interest expense.
A higher interest coverage ratio is preferred as it indicates that the company has a good cushion to pay its interest expense.
A very low ratio indicates that a high proportion of the operating earnings of the company is spent on interest payments. It can be dangerous if the profits start falling.
Interest Coverage Ratio of 1 implies that the earnings of the company are exactly equal to the interest expense. An Interest Coverage Ratio of less than 1 is always a bad sign, as the operating profit of the company is not sufficient to meet its interest expenses.
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How to Calculate ICR?
The formula for calculating the Interest Coverage Ratio is usually expressed as:
Interest Coverage Ratio = EBIT / Interest Expense
Where:
- EBIT stands for Earnings Before Interest and Taxes.
- Interest Expense is the interest payable by the firm.
Let us understand this with a simple example:
Suppose a company has the operating profit or EBIT of ₹80 crore. The company has borrowed money from banks and other financial institutions, which leads to an interest expense of ₹20 crore per year.
Calculating the interest coverage ratio using the above formula:
ICR = EBIT ÷ Interest Expense
ICR = ₹80 crore ÷ ₹20 crore
ICR = 4 times
Interest Coverage Ratio of 4 implies that the company makes four times its interest expense annually through its operating income.
Let us assume that the EBIT is reduced to ₹40 crore, whereas the interest expense remains ₹20 crore.
Then the new interest coverage ratio will be:
₹40 crore ÷ ₹20 crore = 2 times
The company’s capacity to meet its interest expense has reduced.
Suppose EBIT of the company decreases to ₹15 crore.
₹15 crore ÷ ₹20 crore = 0.75 times
Now the ratio is less than 1. This indicates that the company's operating profit is insufficient to pay off its interest expense.
The above example demonstrates why investors should not consider the current Interest Coverage Ratio only. Instead, they need to analyze how the ratio has performed over the last few years.
Importance of Interest Coverage Ratio in Fundamental Analysis
The interest coverage ratio can give useful information while doing fundamental analysis.
- Measures debt-servicing ability: Interest Coverage Ratio lets investors know whether the company will be able to service its interest through operating income. This is especially true for companies with high levels of debt.
- Helps identify financial risk: Companies that have low Interest Coverage Ratio are more vulnerable during hard economic times. In case there is a reduction in sales and profitability, the company may find it hard to service its interest.
- Useful for comparing companies: Interest Coverage Ratio can be used to compare different companies that operate within the same industry. Investors can see which company is better in terms of servicing debt, even though industry differences should be taken into consideration.
- Shows the impact of debt: Some companies may borrow money for growth. Although this will lead to higher profits, it will also result in increased interest expenses. The Interest Coverage Ratio can help investors to know if the company is comfortably servicing its debt.
- Useful for lenders: Banks and other financial institutions also consider interest coverage when analyzing the company's creditworthiness.
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Benefits of Interest Coverage Ratio
- Identifies risk related to debt: Interest coverage ratio can help identify those companies that have high debt-related risks. A low or falling ratio may indicate that the interest expense is becoming increasingly difficult for the company to pay from its earnings. A continuing decline over several years may require the investor to analyze the debt and profitability of the company.
- Helps compare companies: It can be useful in comparing companies that operate in the same industry. It allows investors to see which of the companies has a better ability to cover its interest expenses. The comparison should be done between companies that have the same business model and operating environment.
- Tracks financial performance: The ratio can also be used to study changes in the financial performance of the company over the years. It is better to consider the ratio for several years rather than one year because it can give more useful information. An improving interest coverage ratio may indicate better debt-servicing ability of the company, whereas a falling ratio may suggest growing financial risk.
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Limitations of Interest Coverage Ratio
- Does not measure debt repayment ability: Interest coverage ratio is primarily used to indicate a firm's ability to service interest payments. It does not directly show whether the firm can repay the principal amount of its debt obligations. The firm may be able to earn enough money to cover its interest payments but may find it difficult when its loan repayments fall due.
- Does not show actual cash flow: It is generally calculated using accounting earnings such as EBIT rather than actual cash flow. Though the firm may have high operating income but low cash flow due to working capital needs or capital expenditure. Interest coverage ratio should not be regarded as an indicator of cash flow.
- Varies across industries: The ratio may differ among industries. Companies having stable and consistent earnings may find a different level acceptable in comparison to firms operating in cyclical industries. In such a case, the investors should compare a firm's interest coverage ratio with those of other firms in the same industry.
- Based on historical information: It is typically calculated using the past period's financial data. Past performance does not assure future performance. The earnings, debt, interest rates, and business environment of the firm may change in the future.
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Conclusion
The interest coverage ratio is an important analytical tool for understanding the company’s ability to pay off interest payments. This ratio connects a company's operating earnings with the cost of its debt and provides investors with a simple way to assess interest-related financial risk.
A high ICR value indicates that a company is comfortably positioned to pay interest, whereas a low value may indicate increased financial strain. There is no such ratio that can help determine whether a company is a good or bad investment.
