When it comes to risk management, the interest coverage ratio is one of the most valuable financial metrics using it businesses, analysts or equity investors could easily understand the existing obligations of a company to pay down the interest on the debt liabilities.
The interest coverage ratio gives an obvious snapshot of the short-term financial nature of a company.
Investors can evaluate the interest coverage ratio to know whether the companies in the safety zone so far return on investment is concerned. One must find out more than only the definition of interest coverage ratio.
What is the Interest Coverage Ratio?
The interest coverage ratio is a solvency ratio that gauges the ease with which a company can pay its interest expenses on outstanding debt.
In another word the interest coverage ratio or a short, ICR reveals how a company easily pays the interest expenses on its outstanding debt. Whenever a company borrows money, it has to pay interest.
This measurement is used by lenders, creditors and investors to determine the riskiness of lending capital to a company.
If a company can't afford its interest expenses on its existing debts, this company may not be able to pay off the principal amount.
The interest coverage ratio is also called ' times interest earned and the time interest earned ratio is a crucial financial tool that nurtures to infer how efficiently a company can pay off its current liabilities.
Interest Coverage Ratio Formula
The interest coverage ratio is calculated by dividing earnings before interest and taxes by interest expenses or in a nutshell EBIT in the same financial year.
The interest coverage or time interest earned ratio formula following:
Interest Coverage ratio = (EBIT / Interest expenses)
Where EBIT or earnings before interest and taxes is also called operating profit.
Finance costs or interest expenses including any borrowing funds such as bonds, loans, credit card debt etc.
Interest Coverage Ratio Example
Suppose, It is an ABC company. Here is some information about ABC company,
Statement of Profit & loss for the year ended on 31.03.19
| Particular | Amount (Rs.) |
|---|---|
| Revenue | 10,00,000 |
| Others Income | 500,000 |
| Total Income | 15,00,000 |
| Expenses | |
| Salaries | 300,000 |
| Finance Cost | 150,000 |
| Utilities | 90,000 |
| Inventory | 210,000 |
| Total Expenses | 750,000 |
| EBT | 750,000 |
| Tax @ 30% | 225,000 |
| Net Profit | 525,000 |
EBIT = 525,000 + 225,000 + 150,000 = 900000
Interest coverage ratio = ( 900000 / 150000 )
Interest coverage ratio = 6 times
As per the result, the interest coverage ratio is 6 times which indicates ABC can meet its interest cost 6 times over. The ABC company is in a good position.
Interest Coverage Ratio Analysis
The interest coverage ratio is an important financial metric that measures how many times earnings can pay the interest on the existing debt.
Interest coverage is one of the most essential debt ratios that could be used to analyze the financial condition of a company.
A higher interest coverage ratio Indicates more safety to provide to the debt shareholders and also the company is generating more than enough money to pay its interest and strong solvency of the company. A high interest coverage ratio is used.
A lower interest coverage ratio infers the company does not generate enough cash to fulfil its interest obligations and the possibility of bankruptcy.
Those types of companies are risky for investors. An investor should have sold the stock when the ratio dropped below 1.5 which every investor should keep in mind. The interest coverage ratio is given a clear picture of the company's borrowing fund.
This ratio can also be useful to compare to the ability of various companies to pay off their interest expenses, which may assist in making an investment decision and better to find out a trend of the past five years interest coverage ratio, that would give a clear picture about the company.
Thus the stability of the interest coverage ratio is one of the most valuable factors when assessing the interest coverage ratio.
Overall, the interest coverage ratio is a reasonable estimation of the short-term financial health of a company. Moreover, a high-interest coverage ratio is more reliable than a lower coverage ratio.
What is a good Interest Coverage Ratio?
A good interest coverage ratio would serve as a good indicator of the situation and potentially as a pointer of the ability to pay off the obligation of the company.
A good interest coverage ratio is considered when a company pays off the interest expense on its debt obligations to the creditors.
A ratio of less than 1 reflects that the company is struggling to generate adequate cash to pay back its interest debts.
A ratio below 1.5 indicates the company may not be able to pay its interest on the outstanding debt.
As a rule of thumb, an interest coverage ratio should be above 3, which would be acceptable for the companies.
Sometimes an interest coverage ratio of 2 to 3 may be acceptable for stable cash flow companies like electricity, natural gas, etc. Similarly, industries with fluctuating sales like technology, manufacturing, etc. axiomatic a higher interest coverage ratio.
Importance of Interest Coverage Ratio
The few importance of the interest coverage ratio following:
1. A detailed study of the interest coverage ratio assists to serve a reasonable indication of the sustainability of the company when it comes to interest payable on its current debts.
2. This is an important ratio for stakeholders like creditors and investors to use the ratio to make investment decisions at the right time.
3. The interest coverage ratio offers important insight into the company's strength when it comes to paying back interest.
4. The interest coverage ratio assists to estimate the creditworthiness of a company before increasing creditworthiness.
5. The interest coverage ratio measures the short term financial health and short term financial stability of a company.
Limitations of Interest Coverage Ratio
Here are some limitations of the interest coverage ratio that should be aware of this.
The limitations are following:
1. The interest coverage ratio can differ in different industries and is highly variable. Hence the investors get puzzled to make investment decisions.
2. The companies may isolate or exclude certain kinds of debt while evaluating the interest coverage ratio.
3. The interest coverage ratio does not affect the tax expenses on a company's cash flow.
4. The interest coverage ratio mostly focuses on the short-term capacity to fulfil the interest payment company as it is founded on the existing earnings and expenses.
Conclusions
While analysing the financial statements such as balance sheet, income statement and cash flow of a company, investors should use interest coverage ratio along with other ratios also like current ratio, debt to equity ratio, quick ratio etc.
It will assist to understand the company's short term financial health and stability and will allow it to ease the drawbacks more efficiently. A higher coverage ratio is a more profitable business.
