Interest Coverage Ratio (ICR)

Definition

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 how many times a company could pay the interest on its debt with its EBIT. It determines how easily a company can pay the interest expense on outstanding debt.

Interest coverage ratio is also known as interest coverage, debt service ratio or debt service coverage ratio. The exact origins of the ICR are not clear, but it is a widely accepted and commonly used ratio in financial analysis. Today, many financial analysts and investors use the ICR in conjunction with other financial ratios and information to gain a more complete understanding of a company's financial position.

Calculation (formula)

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.

When calculating the interest coverage ratio (ICR), you should use all of the company's interest expense in the calculation. By using all of the company's interest expense, you will get the most accurate picture of the company's ability to meet its interest payments on its outstanding debt.

It's important to note that interest expense can include more than just the interest on debt. Interest expense can also include capitalized interest, amortization of debt discount and premium, and interest on lease obligations.

Additionally, you should not exclude any extraordinary or non-recurring items such as interest incurred due to an unusual event or accounting changes, as these items can have a significant impact on a company's financial performance and can affect the ICR.

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 high ICR, typically above 3, indicates that the company has a strong financial position and is able to easily meet its interest payments. 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 can indicate that a company is "too safe" and is neglecting opportunities to increase earnings through leverage.

The interest coverage ratio (ICR) is generally considered to be independent of the size of the company. It is a measure of a company's ability to make interest payments on its outstanding debt, regardless of the size of the company. However, it's worth noting that the ICR can be affected by the industry in which the company operates. For example, a highly capital-intensive industry, such as utilities, may have a lower ICR than a less capital-intensive industry, such as retail, due to the higher cost of debt service. Therefore, it's important to use the industry average ICR as a benchmark. In addition, the size of the business can affect the absolute level of debt a company carries and therefore the ICR, but the ratio itself is independent of the size of the business.

Exact formula in ReadyRatios analysis software

Interest coverage ratio = EBIT / F2[FinanceCosts]

F2 – Statement of comprehensive income (IFRS).

There are several sources where you can obtain data to calculate the interest coverage ratio (ICR). Some of the most common sources include:

1. Financial Statements: The most common source for ICR calculation is a company's financial statements, specifically the income statement and balance sheet. The income statement will provide information on a company's earnings before interest and taxes (EBIT), and the balance sheet will provide information on a company's outstanding debt.

2. Annual Reports: Many companies will also provide their financial information in an annual report, which is typically available on the company's website.

3. Online Financial Data Providers: There are several online financial data providers that offer financial information on publicly traded companies. Some popular providers include Bloomberg, Yahoo Finance, and Google Finance.

It's important to note that to calculate the ICR, you will need to have access to the company's earnings before interest and taxes (EBIT) and outstanding debt.

Industry benchmark for ICR

There is our industry benchmark calculated using US SEC data, where you can find average values for interest coverage ratios.

ICR and Credit Rating

The interest coverage ratio (ICR) is one of the financial ratios that credit rating agencies such as Standard & Poor's, Moody's and Fitch consider when determining a company's credit rating. A high ICR indicates that a company has a strong financial position and can easily meet its interest payments, which is generally viewed positively by rating agencies. A low ICR, on the other hand, may indicate that a company is struggling to meet its debt obligations and may be at risk of default, which is generally viewed negatively by rating agencies.

However, it's important to remember that the ICR is only one of many ratios and factors that credit rating agencies consider when determining a company's credit rating. Other factors considered by rating agencies include a company's revenues, assets, liabilities and cash flow. They also consider the industry in which the company operates and the overall economic environment.

Therefore, a low ICR alone does not necessarily mean a low credit rating, but it is a signal that the company may be facing financial troubles and credit rating agencies will look further into the company's financials and other factors to determine the credit rating.

The Interest Coverage Ratio (ICR) is a widely used financial ratio used to evaluate a company's ability to meet the interest payments on its outstanding debt. However, like any financial ratio, the ICR has some limitations and drawbacks:

1. It only considers debt: The ICR only considers a company's interest payments and doesn't take into account other obligations, such as lease payments or dividend payments.
2. Doesn't account for different types of debt: ICR doesn't take into account the different types of debt a company has, such as short-term debt or long-term debt.
3. Can be affected by accounting choices: ICR can be affected by the accounting choices a company makes, such as how it accounts for lease payments or how it capitalizes interest.
4. Doesn't consider future prospects: ICR only considers a company's current financial performance and doesn't take into account future prospects, such as expected growth or expected changes in the industry.
5. Doesn't consider industry averages: ICR doesn't take industry averages into account. Therefore, it's important to use the industry average as a benchmark when evaluating a company's ICR.
6. Doesn't take into account the overall economic environment: The ICR doesn't take into account the overall economic environment, which can affect a company's ability to meet its debt obligations.

It's important to note that the ICR is only one of many ratios and factors that financial analysts and investors use to evaluate a company's financial performance. Therefore, it's important to use the ICR in conjunction with other financial ratios and information to gain a more complete understanding of a company's financial position.