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Interest Coverage Ratio (ICR): Formula and Meaning

DEFINITION:

The interest coverage ratio (ICR) is used to assess a company's riskiness relative to its debt. It shows the company's ability to pay interest on its outstanding debt, i.e., this is the company's solvency coefficient.

FORMULA for calculations:

\[ {Interest\ Coverage\ Ratio} = {EBIT \over Interest\ Expense} \]

Another variation of the formula:

\[ {Interest\ Coverage\ Ratio} = {EBITDA \over Interest\ Expense} \]

WHERE:

  • EBIT - Earnings before interest and taxes
  • EBITDA - Earnings before interest, taxes, depreciation and amortization

RESULT INTERPRETATION:

The higher the ratio, the better. A higher ratio means stronger company's financial strength, the lower the ratio the higher the company's debt burden and greater the risk of its bankruptcy.

Interest coverage ratio is:

  • below 1: business has difficulties generating the cash needed to pay its interest obligations; there is a huge risk to fall into bankruptcy, in case of impossibility to use company's cash reserves and borrow more funds.
  • equal or less than 1.5: company’s risk for default is too high, there could be a probability that creditors refuse to lend the company additional money; company's ability to meet interest expenses is questionable.
  • less than 2: company is burdened by debt, there is a strong probability and high-risk that business cannot pay the interest on its debt.
  • equal or more than 2: minimally acceptable interest coverage for investors.
  • equal or more than 3: business’s revenues are reliable and consistent.
  • equal to 5: company's minimum acceptable interest coverage according to Benjamin Graham

Nevertheless, this metric can vary across industries and even between companies within the same industry.

To get much clearer understanding of a company’s position and its development trajectory it is better to analyze the interest coverage ratios over time. In such analysis, stability in interest coverage ratios plays an important role for investors. The steadily increasing ratio over years indicates a stable company, whereas decreasing interest coverage ratio (ICR) shows that business might face liquidity problems in the future.

EXAMPLE:

Let's suppose, company's Interest coverage ratio is equal to 1,71. This means, that the company can pay its interest payments on its debt 1,71 times using its operating profit.

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