How healthy is your business? How are you getting your business funded? Is debt good or bad? Are you a good or bad borrower? Is my business fit for this debt? Will I be able to pay back the loan? and so on. These questions and many others are questions that can be answered using different financial ratio analyses before decisions are taken.
In today’s business world, it is almost impossible for companies to run businesses without incurring debts or taking risks or interest-bearing loans. So, in order to determine which debt to incur or will a company be able to pay the interest on the current debt? Financial ratio analyses like Interest coverage ratio can be used.
In this post, we will focus our attention on Interest Coverage which is one of the financial ratios (debt and profitability ratio) that business owners, lenders, and investors use to determine how easily a company can pay interest on its outstanding debt. It is sometimes called the Times Interest Earned (TIE) ratio.
The interest coverage ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expense during a given period.
Interest Coverage Ratio (ICR or TIE) = EBIT / Interest Expense.
Where: EBIT is the company’s operating profit (Earnings Before Interest and Taxes) and Interest expense represents the interest payable on any borrowings such as bonds, loans, lines of credit, etc.
Another variation of the formula is using Earnings before interest, taxes, depreciation, and amortization (EBITDA) as the numerator:
Interest Coverage Ratio (ICR) = EBITDA / Interest Expense
The “coverage” in the interest coverage ratio stands for the length of time—typically the number of quarters or fiscal years—for which interest payments can be made with the company’s currently available earnings. In simpler terms, it represents how many times the company can pay its obligations using its earnings within the period.
How to use Interest Coverage Ratio (ICR)?
- To determine the ability of a company to pay its interest expense on outstanding debt.
- Lenders, creditors, and investors use it to determine the riskiness of lending money to the company.
- To determine company stability – a declining ICR is an indication that a company may be unable to meet its debt obligations in the future. Trend analysis of ICR gives a clear picture of the stability of a company about interest payments.
- To determine the short-term financial health of a company.
What does higher or lower Interest coverage mean?
A high ratio indicates that a company can pay for its interest expense several times over while a low ratio is a strong indicator that a company may default on its loan payments.
The lower the ratio, the more the company is burdened by debt expenses and the less capital it has to use in other ways. When a company’s interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable. If it is 1 time, it means the company is only working for the lender.
Some analysts said 3 times Interest coverage is good. This depends on the company and its obligations. The higher the ICR the better for the company to pay its obligations.
How can you increase my interest coverage ratio (ICR)?
The Interest Coverage Ratio can be increased in two ways. One is by increasing the earnings before interest and tax, i.e., EBIT, which could be achieved when revenue increases. Another one is by decreasing finance costs or reducing the interest expense. This could be achieved by constantly analysing the revenue and interest obligation of the company.
Companies need to have more than enough earnings to cover interest payments in order to survive future, and perhaps unforeseeable, financial hardships that may arise. A company’s ability to meet its interest obligations is an aspect of its solvency and is thus an important factor in the return for shareholders.
Good debt is often exemplified in the old adage “it takes money to make money.” If the debt you take on helps you generate earnings that can pay your interest multiple times and build your net worth, then that can be considered positive. Otherwise, you will not be able to meet your obligation and are likely to go bankrupt.
Written by HayRHay
Dealing with Loss