The Interest Coverage Ratio (ICR) is a financial ratio that is used to determine how well a company can pay the interest on its outstanding debts Senior and Subordinated Debt In order to understand senior and subordinated debt, we must first review the capital stack. Capital stack ranks the priority of different sources of financing. Senior and subordinated debt refer to their rank in a company's capital stack. In the event of a liquidation, senior debt is paid out first . The ICR is commonly used by lenders Top Banks in the USA According to the US Federal Deposit Insurance Corporation, there were 6,799 FDIC-insured commercial banks in the USA as of February 2014. The country's central bank is the Federal Reserve Bank, which came into existence after the passage of the Federal Reserve Act in 1913 , creditors, and investors to determine the riskiness of lending capital to a company. The interest coverage ratio is also called the “times interest earned” ratio.
Interest Coverage Ratio Formula
The interest coverage ratio formula is calculated as follows:
Where:
- EBIT EBIT Guide EBIT stands for Earnings Before Interest and Taxes and is one of the last subtotals in the income statement before net income. EBIT is also sometimes referred to as operating income and is called this because it's found by deducting all operating expenses (production and non-production costs) from sales revenue. is the company’s operating profit (Earnings Before Interest and Taxes)
- Interest expense Interest Expense Interest expense arises out of a company that finances through debt or capital leases. Interest is found in the income statement, but can also be calculated through the debt schedule. The schedule should outline all the major pieces of debt a company has on its balance sheet, and calculate interest by multiplying the represents the interest payable on any borrowings such as bonds, loans, lines of credit, etc.
Interest Coverage Ratio Example
For example, Company A reported total revenues of $10,000,000 with COGS (costs of goods sold) Cost of Goods Sold (COGS) Cost of Goods Sold (COGS) measures the “direct cost” incurred in the production of any goods or services. It includes material cost, direct labor cost, and direct factory overheads, and is directly proportional to revenue. As revenue increases, more resources are required to produce the goods or service. COGS is often of $500,000. In addition, operating expenses in the most recent reporting period were $120,000 in salaries, $500,000 in rent, $200,000 in utilities, and $100,000 in depreciation. The interest expense for the period is $3,000,000. The income statement of Company A is provided below:
To determine the interest coverage ratio:
EBIT= Revenue – COGS – Operating Expenses
EBIT = $10,000,000 – $500,000 – $120,000 – $500,000 – $200,000 – $100,000 = $8,580,000
Therefore:
Interest Coverage Ratio = $8,580,000 / $3,000,000 = 2.86x
Company A can pay its interest payments 2.86 times with its operating profit.
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Interpretation of Interest Coverage Ratio
The lower the interest coverage ratio, the greater the company’s debt and the possibility of bankruptcy Bankruptcy Bankruptcy is the legal status of a human or a non-human entity (a firm or a government agency) that is unable to repay its outstanding debts to creditors. . Intuitively, a lower ratio indicates that less operating profits are available to meet interest payments and that the company is more vulnerable to volatile interest rates. Therefore, a higher interest coverage ratio indicates stronger financial health – the company is more capable of meeting interest obligations.
However, a high ratio may also indicate that a company is overlooking opportunities to magnify their earnings through leverage. As a rule of thumb, an ICR above 2 would be barely acceptable for companies with consistent revenues and cash flows. In some cases, analysts would like to see an ICR above 3. An ICR lower than 1 implies poor financial health, as it shows that the company cannot pay off its short-term interest obligations.
Primary Uses of Interest Coverage Ratio
- ICR is used to determine the ability of a company to pay its interest expense on outstanding debt.
- ICR is used by lenders, creditors, and investors to determine the riskiness of lending money to the company.
- ICR is used to determine company stability – a declining ICR is an indication that a company may be unable to meet its debt obligations in the future.
- ICR is used to determine the short-term financial health of a company.
- Trend analysis of ICR gives a clear picture of the stability of a company in regard to interest payments.
For example, let us use the concept of interest coverage ratio to compare two companies:
When comparing the ICR’s of both Company A and B over a period of five years, we can see that Company A steadily increased its ICR and appears to be more stable, while Company B showed a decreasing ICR and might face liquidity issues in the future.
Additional Resources
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