Interest Coverage Ratio (ICR)
The interest coverage ratio (ICR) is a measure of a company's ability to meet its interest payments. Interest coverage ratio is equal to earnings before interest and taxes (EBIT) for a time period, often one year, divided by interest expenses for the same time period. The interest coverage ratio is a measure of the number of times a company could make the interest payments on its debt with its EBIT. It determines how easily a company can pay interest expenses on outstanding debt.
Interest coverage ratio is also known as interest coverage, debt service ratio or debt service coverage ratio.
The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the company's interest expenses for the same period.
Interest coverage ratio = EBIT / Interest expenses
Norms and Limits
The lower the interest coverage ratio, the higher the company's debt burden and the greater the possibility of bankruptcy or default. A lower ICR means less earnings are available to meet interest payments and that the business is more vulnerable to increases in interest rates. When a company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable. An interest coverage ratio below 1.0 indicates the business is having difficulties generating the cash necessary to pay its interest obligations (i.e. interest payments exceed its earnings (EBIT)).
A higher ratio indicates a better financial health as it means that the company is more capable to meeting its interest obligations from operating earnings. On the other hand, a high ICR may suggest a company is "too safe" and is neglecting opportunities to magnify earnings through leverage.
Exact formula in the ReadyRatios analytic software
Interest coverage ratio = EBIT / F2[FinanceCosts]
F2 – Statement of comprehensive income (IFRS).
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