Contents
Search
Advertiser Disclosure

Interest Coverage Ratio

The interest coverage ratio is a measurement of how well a company can cover the interest payments on its debt. It compares a company’s earnings before interest and taxes (EBIT) and its interest expense.

Asset Brief is an independent publisher focused on helping you improve your financial decisions. Some of the products featured may be from our partners. This does not influence our reviews, which are based on many hours of research.

What is the interest coverage ratio (ICR)?

The interest coverage ratio is a measurement of how well a company can cover the interest payments on its debt. It compares a company’s earnings before interest and taxes (EBIT) and its interest expense.

A higher interest coverage ratio signals that a company is well positioned to pay off its interest expense. A lower interest coverage ratio means that a company is not as well positioned.

EBIT is used because this is the stockpile from which a company would pay its interest expense from.

Summary
  • The interest coverage ratio measures how well a company can pay the interest on its outstanding debts.
  • A higher interest coverage ratio is better.
  • A ratio below 1 means the company does not generate enough earnings to pay off its interest expense.

Interest coverage ratio formula

To calculate the interest coverage ratio, use the following formula:

Why is the interest coverage ratio important?

The interest coverage ratio looks at whether a company can pay off its interest expenses. If the ratio is low, this could mean that the company may have trouble paying off interest expenses, and on time.

If a company is unable to make its interest payments to its creditors on time, its ability to get more credit in the future, such as additional loans, may be hurt. When it is able to obtain loans, it may need to pay a higher interest rate, increasing its expenses and decreasing its profits.

In the extreme case, if a company is unable to pay its interest expenses for a long time, the company may end up in bankruptcy.

Example 1

If a company generates an EBIT of $1 million and its interest expense is $1 million, then it has an interest coverage ratio of 1.

This means that it generates $1 for every $1 it pays out in interest.

This may be concerning because if EBIT decreases a small amount, say 10%, the company will not be able to pay all of its interest expense.

Example 2

If a company generates an EBIT of $10 million and its interest expense is $2 million, then its interest coverage would be 5.

You can see how this feels more financially sound.

If the company’s EBIT fluctuated and decreased by 10%, its EBIT would then be $9 million, which more than coverage its interest expense.

Limitations of the interest coverage ratio

A “good” interest coverage ratio varies across industries and companies. For example, an interest coverage ratio of 2 is considered good for utility companies.

Generally, lower interest coverage ratios are accepted in stable industries where earnings are more predictable. In volatile industries where earnings fluctuate, higher interest coverage ratios are wanted.

If a company has no debt, then the interest coverage ratio is meaningful, because the company has no interest expenses.

Calculating the interest coverage ratio

The interest coverage ratio is calculated for a specified time period, such as a quarter or a year. The formula to calculate the interest coverage ratio is:



For a public company, both EBIT and interest expense can generally be found on the income statement, also known as the profit and loss account.

If a company does not have a line for EBIT, it usually will have one for earnings before taxes. You can calculate EBIT by adding back interest expense to earnings before taxes to get EBIT.


What is a good interest coverage ratio?

Typically an interest coverage ratio of 5 or higher is financially sound. An interest coverage ratio of 1.5 to 2 or less is common among financially unhealthy companies. The US Federal Reserve analyzed interest coverage ratios across industries from 1970 to 2017 and found that the average interest coverage ratio was around 3.7.

AssetBrief.com