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.
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.
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
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.
Here are two examples that we will walk through to show the interest coverage ratio calculations.
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.
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.
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
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.
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.
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.
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.
Track metrics like the top performing ecommerce stores.