Debt isn’t always a bad thing, but if your business has a significant amount of debt obligations, you must have enough revenue to cover your interest payments. Otherwise, your company could be at risk of bankruptcy. The interest coverage ratio (ICR) can provide you with an excellent insight into how easily your business can afford to pay interest payments on outstanding debts. Get the inside track, starting with our interest coverage ratio definition.
Interest coverage ratio definition
So, what is the interest coverage ratio? The interest coverage ratio (ICR) can help you understand whether your company’s revenues are sufficient to pay the interest on your outstanding debt obligations. It’s usually used by lenders and creditors to determine whether you’re a good candidate for a loan. Also referred to as the “times interest earned ratio,” another way to understand the ICR is that it provides you with a measure of how many times your business can cover its interest expenses with its current earnings.
Interpreting the interest coverage ratio
After you’ve completed an interest coverage ratio calculation, you’ll need to interpret the results. However, it’s important to remember that the standard interest coverage ratio is likely to vary dramatically from one industry to another. Broadly speaking, investors will hope to see an interest coverage ratio of around three. This indicates that the company has reliable and consistent revenue streams, meaning lending to them has a minimal level of risk.
By contrast, an interest coverage ratio of one or less indicates that the business’s current revenue isn’t enough to service its outstanding debt obligations. This is usually a red flag for investors and creditors, and it’s unlikely for a business in this position to have success when seeking financing. It’s also worth noting that an interest coverage ratio that’s “too high” could be an indication that you’re playing it safe and could be magnifying your company’s earnings through leverage.
Interest coverage ratio formula
Now, let’s explore the interest coverage ratio formula in a little more depth. Fortunately, it’s a simple calculation that you should be able to complete by hand, provided that you have access to a couple of key pieces of information:
Interest Coverage Ratio = EBIT / Interest Expenses
Here, “Interest Expenses” is the aggregated interest that’s payable on all your business’s debt obligations, including loans, bonds, and lines of credit. EBIT (earnings before interest and taxes) is another word for operating profits. If you’re not sure what they are, you can use the following formula to work it out:
EBIT = Revenue – Cost of Goods Sold – Operating Expenses
Variations on the interest coverage ratio calculation
There are several variations on the interest coverage ratio formula that you may wish to use in place of the standard ratio mentioned above. The most common variation replaces EBIT with EBITDA (earnings before interest, taxes, depreciation, and amortization). Calculating the interest coverage ratio with EBITDA will often provide you with a better result, as depreciation and amortization are excluded.
Another potential interest coverage ratio formula you can use applies EBIAT (earnings before interest after taxes) instead of EBIT. This is a much more stringent ratio and provides you with the best insight into your company’s ability to cover its interest expenses. However, it’s also important to note that using EBIAT in your interest coverage ratio calculation will likely provide you with a worse result.
Limitations of the interest coverage ratio formula
The main drawback of the interest coverage ratio is that it’s so variable when measuring companies in different industries. For established companies in highly-regulated sectors, such as a utility company, a lower interest coverage ratio may be acceptable. However, other industries are far more volatile, meaning that the minimum interest coverage ratio will need to be higher. As such, you should only use the interest coverage ratio calculation to compare businesses from the same industry. If possible, the formula should only be used for comparisons of businesses with similar business models.
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