What is Interest Coverage Ratio (ICR)? – Definition
The interest coverage ratio is aimed at indicating how well can a company service its long term loans. ICR is calculated by dividing net profit (before deducting the interest) by the total interest expenses and is expressed in times. The interest coverage ratio is also known as the debt service ratio or debt service coverage ratio. Times interest earned or ICR is a measure of a company’s ability to honor its debt payments. It may be calculated as either EBIT or EBITDA divided by the total interest expense of the company.
This is an important and much-studied ratio, especially when borrowing is high relative to shareholders’ fund. This situation, known as being highly geared, is explained here. It is also particularly significant when the interest charge is high relative to profits. Obviously a company that cannot pay its interest charge has severe problems and might not be able to carry on, at least not without a fresh injection of funds.
Interest cover is profit before interest and tax divided by the interest charge. the higher the resulting number the more easily the business is managing to pay the interest charge.
Interpretation of interest coverage ratio:
If the Interest coverage ratio is high, it shows that interest payments are not a major part of the company’s total expenses and the company is therefore likely to be able to service them comfortably. However, if the ICR is low, it means even a small drop in the company’s operation levels can make payment of interest difficult for the company. Lenders are therefore very concerned about this ratio.
A highly geared company, i.e. a company with a high level of borrowings, will generally have a low-interest coverage ratio. Conversely, a low geared company will generally have a high ratio.
Formula to calculate interest coverage ratio
The formula of interest coverage ratio is written as follows:
(i) Earnings before interest and tax are the operating profit of the company.
(ii) Fixed interest expenses indicate all the payable interest on borrowings like bonds, loans, etc.
Interest coverage ratio example:
The following information has been extracted from the Income statement of John Trading Company.
- Interest expenses: $25,000
- Earnings before interest and tax: $300,000
Required: Calculate the interest coverage ratio of John trading company.
Interest coverage ratio = Earnings before interest and tax / Fixed interest expenses
= $300,000 / $25,000
= 12 times
The earnings are 12 times more than the interest expenses of John trading company which shows, the company is comfortable enough for the payment of interest expenses on its borrowings.
Suppose, A company X has the following data:
Total Revenue = $20,000,000
Cost of goods sold: $10,00,000
Salaries = $2,20,000
Rent = $5,00,000
Utilities = $3,00,000
depreciation = $1,50,000
Interest expenses = $3,000,000
Prepare the Income Statement of the Company and calculate Interest Coverage Ratio (ICR).
The income statement of Company X is as below:
* the annual income tax expense of the company is 20%.