Interest Coverage Ratio (ICR)

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.

Explanation

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.

Also Check:  Earnings yield 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:

Interest Coverage Ratio Formula

Where:


(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.

Solution:

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.

Example 2:

Suppose, A company X has the following data:

Total Revenue = $20,000,000

Cost of goods sold: $10,00,000

Operating Expenses:

Salaries = $2,20,000

Rent = $5,00,000

Utilities = $3,00,000

depreciation = $1,50,000

Interest expenses = $3,000,000

Required:

Prepare the Income Statement of the Company and calculate Interest Coverage Ratio (ICR).

Solution

The income statement of Company X is as below:

Also Check:  Dividend coverage ratio

Interest Coverage Ratio Example-Solution

* the annual income tax expense of the company is 20%.

Interest Coverage Ratio Calculator

Income before interest and tax:
Interest expenses for the period:
Result:

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