Interest Coverage Ratio

Interest Coverage Ratio (ICR) measures a company's ability to make its interest payments. The ICR formula is operating profit (EBIT) divided by interest expense. In this free guide, we walk through the formula, the definition, review examples, and share other solvency ratios.

What is Interest Coverage Ratio?

The interest coverage ratio (ICR), also called times interest earned (TIE) ratio, is a debt ratio that measures the long-term solvency of a company.

The metric shows how comfortably a business can use its profit to cover interest payments and other debt-related expenses. Lenders will often use this ratio to determine if a company can take on additional debt.

Solvency ratios look at the long-term viability of a business, where liquidity ratios look at the short-term ability for a company to pay its debts and obligations. Both are useful views into understanding the financial health of a company.
The formula is operating profit divided by interest expense. Operating profit is a line item on the income statement and may also be referred to as earnings before interest and taxes (EBIT). These two terms mean the same thing.
Interest expense is a non-operating expense on the income statement. The line item represents the interest payments made to cover bonds, loans, or lines of credit in the given period. It does not include the total debt repayment, that information is on the balance sheet.

Interest Coverage Ratio Formula

The interest coverage ratio formula can be written one of two ways:

Interest Coverage Ratio = Operating Profit / Interest Expense

Interest Coverage Ratio = Earnings Before Interest and Taxes / Interest Expense

They will both get you the same result, as operating profit is just another name for earnings before interest and taxes (EBIT). The ratio is expressed as the number of times that earnings can cover interest payments. A ratio of 1.0x means that EBIT is exactly equal to its interest expense, and is a low interest coverage ratio.
The interest coverage ratio is operating profit divided by interest expense.

If a company has multiple types of debt (e.g., short-term loans, long-term loans, and bonds), then it might make sense to track ICR for each major grouping. Unless explicitly told, you can assume that ICR is looking at all outstanding debt obligations.

In addition, there are variations of the ICR that uses a company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) since depreciation and amortization are non-cash activities. The ICR using EBITDA will be higher than the ICR using EBIT, since EBITDA comes before EBIT on the income statement.

A higher interest coverage ratio means that the company is in a safer position and has more profit to cover its interest expense. A lower interest coverage ratio means the company has less margin of safety and could be at risk of defaulting on its debt, or even have a risk of bankruptcy.

Interest Coverage Ratio Examples

Here are two examples that we will walk through to show the interest coverage ratio calculations.

Company A

  • April EBIT: $550,000
  • April Interest Expense: $50,000
  • May EBIT $575,000
  • May Interest Expense: $50,000
  • June EBIT: $600,000
  • June Interest Expense: $50,000

Now let’s use the formula to calculate the interest coverage ratio…

ICR = EBIT / Interest Expense

ICR April = $550,000 / $50,000 = 11.0x

ICR May = $575,000 / $50,000 = 11.5x

ICR June = $600,000 / $50,000 = 12.0x

The ratio looks very healthy for Company A because there is plenty of operating profit to cover the interest payments, and the trend is positive as well.

Company B

  • April EBIT: $1,000,000
  • April Interest Expense: $500,000
  • May EBIT $900,000
  • May Interest Expense: $500,000
  • June EBIT: $800,000
  • June Interest Expense: $500,000

Let’s calculate ICR for Company B…

ICR April = $1,000,000 / $500,000 = 2.0x

ICR May = $900,000 / $50,000 = 1.8x

ICR June = $800,000 / $50,000 = 1.6x

Company B has a worrying trend. Despite starting out at 2.0x, the ICR has declined every period and is currently at 1.6x. Anything near 1.5x is concerning and management should take a close look at what is causing their profit to decline.

Remember that this ratio looks at how many times a business can cover current interest payments with its available earnings.

A higher number is deemed safer and less risky. A lower number is deemed more risky and, if the number is too low, could signal a possibility of bankruptcy.

Why Is The Interest Coverage Ratio Useful?

The interest coverage ratio is useful because it helps to understand how much margin of safety a business has compared to its debt level. As a company takes on more debt, the interest payments will keep stacking up.

To get more details, let’s recreate an entire pro forma income statement. This is a fictitious income statement for Acme Inc. in 2020.

Acme Inc. Income Statement, Fiscal Year 2020

  • Total Revenue: $3,000,000
  • Cost of Goods Sold: $1,800,000
  • Gross Profit: $1,200,000
  • Operating Expense: $800,000
  • Operating Profit (EBIT): $400,000
  • Interest Expenses: $100,000
  • Tax Expenses: $75,000
  • Net Income: $225,000

The ICR for Amce Inc. in 2020 was 4.0x ($400,000 of EBIT divided by $100,000 of interest expenses incurred in that year). This is at a healthy level and puts the company in a good position. They have some debt, which they are using effectively but not so much as to burden the company.

The income statement by itself provides a wealth of information, but there are also plenty of metrics and ratios that can be gained by comparing income statement values.

For example, operating profit margin is operating profit divided by total revenue. In this case, it would be 13.3%.

Debt Ratios

When evaluating debt, there are two common categories of financial ratios. Solvency ratios look at the long-term health of the company’s debt levels, while liquidity ratios look at the company’s short-term ability to meet interest payments.

Solvency Ratios

Liquidity Ratios

Debt needs to be carefully managed. We recommend that companies build a dashboard to keep track of these debt ratios. If possible, reviewing debt ratios weekly as part of a budget meeting is a great way to make sure they are being calculated often and the team is putting eyes on them.

At a minimum, we suggest looking at solvency and liquidity ratios every month.

Final Thoughts

Interest coverage ratio (ICR), also called times interest earned (TIE) ratio, is a financial ratio used to understand the financial health of a business. Business owners, managers, investors, and lenders will look to ICR to see if a company has enough profit to make its current borrowing.

Equity investors will look for a healthy capital structure and a stable business that does not have an excessive debt burden. Creditors will want to be sure that the company can repay the principal plus interest obligations on any outstanding debt before lending new money to the company. Both equity and debt investors will look for stability in ICR as a positive sign.

All things equals, a higher ICR is better. A higher ratio means the company is in a more stable position and has profit that is many times larger than its interest payments. A lower ratio means that the company’s profit is too, debt level is too high, or both.

ICR can be improved by growing a company’s earnings or by reducing a company’s interest expenses. Looking at times interest earned (TIE) over multiple periods can help uncover trends. A positive sign is TIE being stable or steadily increasing as the months go by.

Both solvency and liquidity ratios are useful when analyzing a company’s debt position. Solvency looks at the long-term viability and health, whereas liquidity focuses on the company’s short-term ability to cover interest expenses with the cash and current assets on hand.

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