What is Interest Coverage Ratio – Formula and Calculation

Debt is a double-edged sword in business. While it provides the necessary fuel for expansion and innovation, it also brings a financial commitment that can strain a company’s resources if not carefully managed. To ensure that the debt obligations are met, the business needs to have sufficient profit, and that is when the Interest Coverage Ratio becomes a valuable tool that helps to assess how many times a company’s earnings can cover its interest payments. 

Lenders and credit rating agencies often use this ratio to assess a company’s creditworthiness before granting loans. Investors, on the other hand, analyze this ratio to understand the sustainability of a company’s debt levels and to know whether it can withstand economic downturns or fluctuations in revenue. 

In this article, we will conceptually dive deep to understand the interest coverage ratio meaning, its formula, calculation, and interpretation.

Interest Coverage Ratio Meaning

The Interest Coverage Ratio (ICR) is a financial metric that shows how easily a company can pay interest on its outstanding debt. With the help of this ratio, we will get to know the number of times a company’s profit can be used to pay interest expenses on its debt. 

The interest coverage ratio is a part of the solvency ratio, which tells us about a company’s ability to meet its long-term financial obligations. More specifically, the solvency ratio compares the company’s profitability with its financial obligations to determine whether the company will be able to meet such obligations without any hurdles. Alongside the Interest Coverage Ratio, there are several other key ratios under the solvency ratio, like the Debt-to-Assets ratio, Debt ratio, Proprietary ratio/ Equity ratio, and Debt-to-Equity ratio.

Types of Interest Coverage Ratios

While the Interest Coverage Ratio (ICR) is commonly calculated using EBIT, many companies and financial analysts use different approaches and variations to gain deeper insights into a company’s ability to meet interest obligations. Let us look at each one of them now.

1) EBIT-Based Interest Coverage Ratio

This is the most common type of ICR, where Earnings Before Interest and Taxes (EBIT) is used as the numerator to measure a company’s ability to cover interest payments using operating profits. 

It can be used when you want to analyze a company’s ability to pay interest based on its operating profits. Additionally, this ratio is suitable for businesses where depreciation and amortization do not significantly impact earnings. 

2) EBITDA-Based Interest Coverage Ratio

This ratio is calculated using EBITDA, which includes depreciation and amortization. Using EBITDA instead of EBIT helps you assess a company’s true ability to pay interest without the effect of these non-cash deductions.

Some businesses (like those in manufacturing) have high depreciation costs due to expensive equipment. As a result, even though their EBIT appears lower, they may still generate enough cash to cover interest payments.

3) EBITDA Less CapEx Interest Coverage Ratio

This is another variation under the Interest Coverage Ratio in which the capital expenditure of the company is deducted from its EBITDA and then taken into consideration for calculating the ICR. 

This type of ICR can be used by capital-intensive industries like manufacturing, energy, or real estate, where businesses must regularly spend on their capital investments. Furthermore, this ratio will help us to understand if the company generates enough excess cash to cover interest expenses after necessary investments are made.

4) EBIAT Interest Coverage Ratio

Unlike traditional EBIT-based ICR, which ignores taxes, EBIAT-based ICR accounts for tax expenses before calculating the interest coverage ratio. This provides a realistic view of how much earnings are actually available to pay interest after accounting for taxes. 

Interest Coverage Ratio Formula

The formula of Interest Coverage Ratio slightly varies depending on the method used, as discussed below.

• EBIT-Based ICR:
  Interest Coverage Ratio = EBIT / Interest Expense
  

• EBITDA-Based ICR:
  Interest Coverage Ratio = EBITDA / Interest Expense
  

• EBITDA Less CapEx ICR:
  Interest Coverage Ratio = (EBITDA - CapEx) / Interest Expense
  

• EBIAT-Based ICR:
  Interest Coverage Ratio = EBIAT / Interest Expense,
  where EBIAT = EBIT × (1 - Tax Rate)

Factors Affecting the Interest Coverage Ratio

The Interest Coverage Ratio is influenced by several financial and operational factors. Understanding these factors will help you in evaluating a company’s ability to meet its interest obligations effectively. We have stated a few major determinants that affect the ICR.

1) Industry Type:

As we all know, there are various types of industries in the market, and each industry will have its own ICR standards. For example, a cost-intensive or capital-intensive industry like oil and construction operates on a high level of debt or lower margins, which leads to a lower Interest Coverage Ratio. 

2) Debt Levels and Capital Structure: 

The companies that rely heavily on debt financing will have higher interest expenses, leading to a lowered Interest Coverage Ratio. However, companies that fund operations through equity or retained earnings will avoid interest costs, leading to a stronger ICR. In other words, less debt financing will lead to lower interest expenses, resulting in a higher Interest Coverage Ratio.

3) Earnings Before Interest and Taxes (EBIT):

A company with strong revenue growth and low operating expenses will have higher EBIT, which leads to having higher Interest Coverage Ratio. Whereas declining sales, rising expenses, or operational inefficiencies will lead to low EBIT, resulting in a lower Interest Coverage Ratio.

4) Tax Rates:

The tax amount reduces the total money available to pay interest. So, the companies with higher corporate tax rates will have lower post-tax earnings, leading to lower ICR. But for the companies with lower tax rates, the post-tax earnings will be higher, and this leads to higher ICR. This factor becomes relevant when we make use of the EBIAT Interest Coverage Ratio. 

5) Non-Cash Expenses:

The industries that rely more on heavy equipment or heavy assets (like manufacturing and construction) have large depreciation and amortization costs, which reduce the EBIT value, due to which the ICR value also comes down. Whereas, companies that do not rely much on heavy equipment (like apparel) will not face huge depreciation costs, leading to high ICR. But, we must keep i mind that this factor is prominent when the EBIT-based Interest Coverage Ratio concept is put into use. 

Interest Coverage Ratio Interpretation 

What defines a good interest coverage ratio differs not only across industries but also among the companies within the same industry. Below, we have stated some key insights about the interpretation of the ICR ratio. 

• 1 or below: A lower ICR will tell us that the company is not been able to meet the cost incurred from debt efficiently and may potentially default on its liabilities. This could lead to financial distress, loss of investor confidence, and potential bankruptcy if the issue is not addressed.

• 1.5 to 2: An interest coverage ratio within this range indicates that the company generates sufficient earnings to meet its interest obligations and manage its debt effectively. This means that the company is not at immediate risk of default because of which means the company is seen as a moderately safe investment. However, while the company can manage its interest payments, it may still need to maintain consistent earnings growth to avoid future financial strain.

• More than 2: A high Interest Coverage Ratio indicates that the company generates significantly more earnings than its debt costs, allowing it to easily fulfill its financial obligations. This means that the company has enough financial resources to comfortably pay off its debt obligations without any financial strain. 

Example of Interest Coverage Ratio

Let us understand this concept with the help of an example and the following particulars.

• Assume that Company A has a net income of Rs 6,00,000. 

• The EBIT of the company stands at Rs 10,00,000.

• The EBITDA is Rs 13,00,000. 

• The company’s capital expenditure is Rs 2,00,000.

• The depreciation and amortization value is Rs 3,00,000. 

• The interest expense amounts to Rs 2,00,000. 

• The profit is taxed at 30%. 

Based on this information, let us understand how to calculate interest coverage ratio using its different types.

1) Calculation of EBIT-Based Interest Coverage Ratio

ICR = EBIT / Interest Expense = 10,00,000 / 2,00,000 = 5

Interpretation: The company’s operating profit is 5 times its interest expense, indicating strong financial stability. 

2) Calculation of EBITDA-Based Interest Coverage Ratio

ICR = EBITDA / Interest Expense = (10,00,000 + 3,00,000) / 2,00,000 = 6.5

Interpretation: Since EBITDA adds back non-cash expenses (depreciation and amortization), this ratio provides a better measure of available cash flow to cover interest payments. Additionally, 6.5 is a strong ICR only.

3) Calculation of EBITDA Less CapEx Interest Coverage Ratio

ICR = (EBITDA - CapEx) / Interest Expense = (13.00,000 - 2,00,000) / 2,00,000 = 5.5

Interpretation: This ratio considers capital expenditures, which are necessary investments for business growth, making it a more realistic measure of interest coverage after reinvesting in the company. Here, a 5.5 ICR shows that the company stands in a good position to pay its interest expenses on debt obligations even after capital expenditures. 

4) Calculation of EBIAT Interest Coverage Ratio

ICR = EBIAT / Interest Expense = [10,00,000 (1 - 0.30)] / 2,00,000 = 3.5

Interpretation: Here, the interest coverage ratio considers taxes before assessing the company’s ability to pay interest. A 3.5 ICR is considered to be a good one, too.

5) Calculation of Fixed Charge Coverage Ratio

ICR = (EBIT + Fixed charges) / (Interest expenses + Fixed charges) 

Here, since there are no such fixed charges excluding interest expenses, we consider interest expense itself to be the fixed charges, i.e., Interest expenses = fixed charges.

Therefore, (10,00,000 + 2,00,000) / 2,00,000 = 6

Interpretation: An FCCR of 6 means the company earns 6 times the amount needed to cover its fixed financial obligations, i.e., here, interest payments. This also indicates strong financial health and a low risk of defaulting on debt payments. 

Strategies to Improve the Interest Coverage Ratio

A company can improve its Interest Coverage Ratio by either increasing the numerator (as in earnings) or reducing the denominator (interest expenses). Here, we have stated some effective strategies that can improve your ICR value. 

1) Revenue: 

One effective way of increasing the numerator is to start having more revenue in your company. You can do this by expanding the market share, optimizing pricing strategy, and can also improve operational efficiency.

For example, a company can implement cost-cutting measures and sell more of its products to increase the EBIT value, leading to a higher Interest Coverage Ratio.

2) Interest Expenses: 

Another prominent way of improving your ICR value is by reducing the interest expenses in the denominator. This can be done by negotiating for lower interest rates, switching to other means of financing rather than debt, or making early debt repayments. 

3) Reduce Debt Levels: 

A company can reduce its debt and bring down interest expenses. This measure can be taken by avoiding excessive borrowing and maintaining an optimal capital structure by balancing both equity and debt. Additionally, the company can restructure its debt levels by converting short-term high-interest loans into long-term low-interest loans. 

Limitations of the Interest Coverage Ratio

Now that we have understood the major topics under ICR, let us also understand the limitations of the Interest Coverage Ratio.

1. Ignores principal repayments: ICR only measures a company’s ability to pay interest, not the principal. A company may have a good ICR but still struggle to repay its debt principal, causing financial strain.

2. Industry comparisons can be misleading: ICR varies widely across industries. Capital-intensive industries often have lower ICRs than service industries, making cross-industry comparisons unreliable.

3. Can be manipulated: Accounting adjustments like one-time revenue boosts or delayed expenses can artificially inflate ICR, misleading investors about a company’s true financial position.

4. Overlooks future investment needs: A high ICR does not guarantee long-term strength. Companies reinvesting in growth might show a lower ICR but still have a solid future outlook. 

Conclusion

The Interest Coverage Ratio (ICR) serves as a financial checkpoint, revealing how well a company can manage its expenses related to its debt obligations. While a higher ICR is often related to financial stability, a lower ICR raises concern about the financial ability of the company. 

Additionally, a business’s success depends on more than just its ability to cover interest, it requires a holistic approach of financial planning, sustainable growth, efficient cash flow management, and debt management strategies. 

So, if you are an investor, don't just look at the ICR but evaluate the company’s overall financial stability. If you are a business leader, don’t just focus on covering the interest, but work towards financial resilience and long-term growth too. Because in finance, true strength lies in the bigger picture!