Interest Coverage Ratio Calculation

Interest Coverage Ratio Calculation

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Interest Coverage Ratio Calculation (ICR) is very important for investment purpose. Interest Coverage Ratio is a financial ratio which is used to measure the ability of a company to pay the interest on its outstanding debt. The word Coverage means the ‘length of time’, it can be a quarter or a month or a year. This is a debt ratio which used to measure the company’s financial condition. This ratio is used by investors and analysts for fundamental analysis, also it is used by bankers or lenders for lending perspective.

Interest Coverage Ratio Calculation

Interest Coverage Ratio Calculation –

Interest Coverage Ratio Calculation can be done by dividing Earning Before Interest and Taxes by Interest Expenses. EBIT is nothing but the company’s operating profit and Interest expenses means the interest company has to pay on their borrowings or debt. EBIT can be calculated by subtracting COGS and Operating cost from Revenue. This ratio is important because it helps investors, analysts, and bankers to understand company’s financials and it tells us how company is managing to pay their interest on their borrowings. Interest Coverage Ratio varies from industry to industry. Normally ratio greater than 3 is good ratio. This ratio is used to determine the short term financial health of a company.

Interest Coverage Ratio (ICR) Formula –

Interest Coverage Ratio Calculation can be done by using following formula,

Interest Coverage Ratio = EBIT / Interest Expenses

EBIT – Earning Before Interest and Taxes

EBIT and Interest expenses can be found in Profit and Loss Statement. The answer we get using this formula shows us how much times EBIT is of Interest Expense. Larger the number is better the ratio.

Interest Coverage Ratio (ICR) Example –

PARTICULARSCOMPANY ACOMPANY B
EBIT100100
Interest Expense5010
Interest Coverage Ratio210

In above example, Earning Before Interest and Taxes or Operating profit of company A is 100 and Interest expenses are 50, so now we will calculate Interest Coverage Ratio,

Interest Coverage Ratio of Company A = EBIT / Interest Expenses

Interest Coverage Ratio of Company A = 100 / 50

Interest Coverage Ratio of Company A = 2

In case of company B, Earning Before Interest and Taxes or Operating profit of company B is also 100, and Interest expenses are 10, now we will calculate Interest Coverage Ratio,

Interest Coverage Ratio of Company B = EBIT / Interest Expenses

Interest Coverage Ratio of Company B = 100 / 10

Interest Coverage Ratio of Company B = 10

In this way, we can do Interest Coverage Ratio Calculation.

Interest Coverage Ratio Calculation

Interest Coverage Ratio (ICR) Meaning –

Interest Coverage Ratio of company A is 2 which means EBIT is 2 times of the Interest expenses of company A. This ratio looks not so good because if the company’s profit decreases due to any reasons then it is going to be very difficult for that company A to manage to pay Interest Expenses. Ratio below 1 is very risky because the ratio 1 means company’s EBIT is same as company’s Interest expenses. If the ratio is below 1 then how company will mange its operations whether they will pay interest expenses or to fund company’s operation, then they will borrow more money. In this way company might go bankrupt.

Whereas, Interest Coverage Ratio of company B is 10. The ratio 10 shows strong financial condition of a company. Ratio 10 means EBIT is 10 times of interest expenses of company B, so company B can easily pay their Interest expenses. Lenders also lend their money to such companies easily and with low interest rates while lenders avoid to provide loans to low interest coverage ratio companies and if they lend, the lends with higher interest rates. That’s why Interest Coverage Ratio Calculation is important.

Interest Coverage Ratio (ICR) Conclusion –

  1. Interest Coverage Ratio Calculation is very important to understand financial condition of a company.
  2. This ratio tells us how much times EBIT is of Interest expenses.
  3. Higher the ratio is better and lower the ratio not a good sign.
  4. Normally the ratio above 3 is better.
  5. ICR varies from industry to industry.
  6. ICR is used to determine short term financial condition of a company.
  7. ICR below 1 is risky for investments.
  8. ICR increasing quarter over quarter or year over year is good sign for company.

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