The interest coverage ratio, or ICR, is a ratio used to calculate a company’s ability to pay off its debts. This debt and profitability ratio can help investors evaluate the risk of investing in a company.
There are different ways to evaluate stocks and decide whether or not to invest in them. The interest coverage ratio, also called “times interest earned,” is one way to do a risk evaluation of a company—because if a company is unable to pay off its debts, its stock may decrease in value or it may go out of business entirely.
Lenders and creditors also use this ratio to decide whether to give loans to companies, to make sure the company will be able to pay them back. A lender will look at the debt a company already has as well as the company’s earnings, to determine the likelihood that the company will be able to pay off a loan.
The ICR can also be a factor in a company’s credit rating and the interest rate it will receive from lenders. It’s possible that a company’s earnings will decrease, so the ICR can help figure out how much of a difference in earnings the company can handle before it starts defaulting on its debts.
The Interest Coverage Ratio Formula
The ICR is calculated by dividing a company’s earnings before interest and taxes (EBIT) by the amount of interest it owes during a certain period of time, generally one year.
Both of these numbers are typically found on the company’s income statement (also known as a profit and loss statement). EBIT is also sometimes referred to as operating profit or operating earnings. If it isn’t stated on the company’s income statement it can be calculated by subtracting operating expenses and cost of goods sold (COGS) from revenues. Interest expenses are sometimes listed as financing costs in the income statement.
Example of Interest Coverage Ratio Formula
Interest Coverage Ratio = EBIT / Interest Expense
Where EBIT = earnings before interest and taxes
For example, if a company’s earnings before interest and taxes are $100,000, and it owes $25,000 in interest within the period one is looking at, then its interest coverage ratio is 4x.
$100,000 / $25,000 = 4
This means that the company’s EBIT covers its interest expenses four times over. A higher ICR means the company carries less risk and is more likely to be able to pay off its debts. If a company has an ICR of 8, for instance, it has eight times as much in EBIT as in debt interest, versus a company with an ICR of 1 that only has enough in EBIT to cover its debt interest one time over.
Variations on the Interest Coverage Ratio Formula
Sometimes, instead of EBIT, EBITDA is used in the formula instead. The EBITDA formula is earnings before interest, tax, depreciation, and amortization. EBITDA is a more specific, and sometimes preferable, earnings metric because it shows earnings that aren’t affected by depreciation and amortization. It’s especially useful to use EBITDA if a company has high depreciation and amortization expenses.
Two adjustments that should be made when calculating EBIT or EBITDA are non-recurring items and any temporary interest income a company receives.
that’s easy to use.
Understanding Interest Coverage Ratio
In addition to evaluating a company’s short term solvency and financial health, ICR can be used to look at a company’s current debt situation, and even to compare the current ratio to past periods of time to see how a company is changing.
It can be useful to calculate ICR for every quarter over the past five years, for instance, in order to see trends and long-term changes. If a company is becoming less able to pay off its debts over time, it’s getting into more and more debt, or its EBIT is decreasing, these may not be good signs. While a high ICR is positive, a stable or increasing ICR is just as important.
In particular, companies that have issued bonds need to make sure that their ICR remains high. If their ICR declines, this can result in a downgrade of their bond credit rating, which lowers the value of the bonds and makes investors less likely to want to buy them.
Once an ICR is calculated, an investor may look into why a company is taking on debt, how they are spending the money, and whether those expenditures are leading to more revenue.
ICR can also be used to compare similar companies to one another. An investor might look at competitors within an industry to evaluate which one may be a better investment or to see how any particular company is performing within its sector.
What Is the Optimal Interest Coverage Ratio?
The amount of risk an investor is willing to take is a personal choice, but in general investors should look for companies that are going to be able to pay off their debts, as well as any unforeseen expenses.
Ideally, a company should have an ICR of 3 or higher—and the higher the better. Additionally, that ICR should have remained steady over time, rather than decline. This shows that the company has a good balance of earnings to debt.
Typically, if a company has an ICR below 1.5 it’s an indication that they’ll barely be able to pay the interest they owe and could be in financial trouble.
It’s also important to recognize that different industries have different standards for what constitutes a healthy ICR. For instance, manufacturing industries can be volatile, so a higher ICR above 3 is preferable, whereas a stable utility company could have an ICR of 2 and be considered a fairly safe investment.
Advantages of Calculating Interest Coverage Ratio
Interest coverage ratio is a popular tool for technical analysis of stocks because it delves into a company’s solvency and risk. It is also easily calculated and easy to understand for both new and seasoned investors.
While no company is a completely safe and risk-free investment, some are certainly better than others. The ICR can help investors decide if an investment aligns with their risk tolerance. It’s an easy way to figure out the short-term financial health of companies and to compare similar companies to one another.
Limitations of the Interest Coverage Ratio Formula
While ICR is a very useful calculation for understanding a company’s solvency, it does have some limitations, as does any evaluation metric. Here are some notable caveats:
• ICR only looks at a company’s interest payments. It doesn’t include the principal amounts that a company has borrowed and its ability to pay those off.
• Companies can defer their interest payments to later dates. This can make it appear as though they have a higher ICR than they do, because their interest payments will be higher in the future. This is one more reason that it’s a good idea to look at a period longer than one year to get a better picture of the company’s long-term solvency.
• ICR isn’t a predictor of future debt and solvency. One could make predictions based on past ICR calculations, but they will not be highly reliable indicators. It’s very difficult to predict a company’s future debt, expenses, and earnings.
In general, it’s best to use ICR in conjunction with other calculations that help value a stock, including the debt-service ratio and the debt-to-assets ratio. The debt-service ratio focuses on any debts a company owes that are due within one year. The debt-to-assets ratio determines the portion of a company’s assets that have been financed with debt. When viewed together, these different ratios can help paint a complete picture of a company’s debt and solvency.
For investors, the interest coverage ratio (ICR) formula is a debt and profitability ratio that can be useful in evaluating a company’s ability to pay back its debts—and consequently, the risk of investing in that company.
When used with other informative metrics—including the debt-service ratio and debt-to-assets ratio—the ICR can help an investor make an informed decision about a company.
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