What Is Interest Coverage Ratio (ICR)?
What Is Interest Coverage Ratio (ICR)?
The Interest Coverage Ratio or ICR is a financial ratio used to determine how well a company can pay its outstanding debts. Also called the “times interest earned ratio,” it is used in order to evaluate the risk in investing capital in that company–and how close that company is to debt insolvency. The ICR is calculated using the Earnings Before Interest and Taxes, or EBIT, and the company’s interest payments due. Both measurements should be taken for the same set period of time, such as the trailing twelve months (TTM).
What Does Interest Coverage Ratio Mean?
The Interest Coverage Ratio shows how many times over a company can pay its current interest on its debts with its cash and assets on hand. Investors are almost always looking for companies that can do so at least more than one time in order to be able to address any crises that may arise in the financial world. In other words, the Interest Coverage meaning is how much of a safety net a company has to pay its debts regardless of how much income it is currently generating.
Interest Coverage Meaning
Like many other financial metrics, the Interest Coverage Ratio is best used by looking at rolling ICRs for the same company over a long period of time to see which way the company is trending. A trend towards insolvency would be a major red flag for potential investors.
Interest Coverage Ratio Formula
The Interest Coverage Ratio formula is a simple division, taking the Earnings Before Interest and Taxes (EBIT) and dividing it by the interest expense. The EBIT is also referred to as the operating profit and is calculated by subtracting total revenue from the money a company owes in interest and taxes. The interest expense is the money due for borrowings such as bonds, loans and lines of credit.
Interest Coverage Ratio Calculation
Determining Bad ICR Ratios
The lower a company’s interest coverage ratio, the closer it is to being unable to pay its debts and risking bankruptcy. The lowest an interest coverage ratio can get while staying above insolvency is 1, so a good rule of thumb is that an ICR of 1.5 or lower should be a major warning sign for investors. If a company has an interest coverage ratio in that range, it is not well protected against a potential disruption in income flow or increase in interest rates.
Determining Good ICR Ratios
What makes up a good interest coverage ratio depends on the industry. If a company has a steady revenue stream less likely to be interrupted by extenuating circumstances, an ICR of at least 2 could be safe enough. For companies in more volatile industries, an investor may want to hold off until he or she sees an ICR at 3 or more, providing a better cushion against a possible decrease in revenue.
What Investors Look For
Investors should also take a look at which direction an company’s ICR is trending over a period of time. If the interest coverage ratio is increasing, the company is increasingly able to cover itself in the event of a revenue disruption. If the interest coverage ratio is decreasing, the company may be on a slide to insolvency.
Interest Coverage Ratio Example
If a company is making $750,000 per quarter in earnings before interest and taxes, and owes $240,000 in debt every six months, the company’s interest coverage ratio would have to be calculated by dividing the debt figure by two (since six months equal two quarters) and then dividing the EBIT by the new amount. So $750,000 / ($240,000 / 2) = $750,000 / $120,000 = an ICR of 6.25. This is a solid interest coverage ratio figure for a decently sized corporation. For reference, Amazon, one of the biggest and most profitable companies on the planet, had an ICR of 8.95 at the end of 2018.
Interest Coverage Ratio (ICR) FAQs
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.