Interest Coverage Ratio: How to Calculate, Meaning

Interest Coverage Ratio: How to Calculate, Meaning

When it comes to risk management, an interest coverage ratio is essential since it enables a firm to evaluate its solvency and determine if its revenues are sufficient to pay the interest on its loan commitments. Although it has nothing to do with online share trading, it is a gauge of a company's stability and financial health, which may be significant factors for investors.

In simple terms, the interest coverage ratio means to measure a company's capacity to pay interest on existing debt is the interest coverage ratio, a debt and profitability metric. Divide a company's earnings before interest and taxes (EBIT) by its total interest expense for a certain time period to get the interest coverage ratio. 

The interest coverage ratio is also known as the times' interest earned (TIE) ratio. Lenders, investors, and creditors regularly employ this technique to determine how risky it is for a firm to borrow money in the future or for its current debt. Let's study the importance of interest coverage ratio in the stock market now that we understand what interest coverage ratio is. 

Significance of the Interest Coverage Ratio

The following outlines the significance of the interest coverage ratio:

  • The challenge of continually paying interest charges is one that many firms have to face. For every firm, keeping up with interest payments is a significant and ongoing concern. A revenue stream is required for solvency and liquidity to satisfy these liabilities. A corporation may be forced to spend its cash reserve or take out further loans if it is unable to pay its debts. Such cash would be better used to purchase capital goods or cover emergencies.
  • A company's current financial situation may be greatly revealed by a single interest coverage ratio. A company's position and direction, nevertheless, may be revealed by examining it over time.
  • Regular review of the Company's interest coverage ratios over the past several years is advised as it provides an indication of the company's short-term financial health and can show whether the ratio is improving, dropping, or steady.
  • Additionally, the corporate analyst has considerable influence over whether a specific level of this ratio is accepted. In exchange for a higher loan interest rate, certain banks, investors, and lenders can be willing to accept a lower ratio.

Know more about emi calculator

Start Your Stock Market
Journey Now!

50 Years Trust |₹0 AMC |₹0 Brokerage *

Table of Content

  1. Significance of the Interest Coverage Ratio
  2. Different Interest Coverage Ratio Types
  3. Limitations of the Interest Coverage Ratio
  4. What is the Interest Coverage Ratio Formula?
  5. Conclusion

Different Interest Coverage Ratio Types

It is critical to understand two very regular variations of the interest coverage ratio before assessing the company's interest coverage ratio. These variations are due to modifications to EBIT.

EBIT stands for Earnings Before Interest and Taxes. The company's operational revenue, which consists of sales income and operating expenses, is known as Earnings Before Interest and Taxes (EBIT). EBIT may be calculated in two different methods. 

One approach is to increase the net operating income by the sum of the taxes and interest due. Taxes and interest are added back in since they were originally subtracted. Simply glancing at the operational income line item on the profit and loss statement is the second approach. 

EBIT is calculated as revenue less cost of goods sold less operating costs.
 

1. Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA): 

Earnings before interest, taxes, depreciation, and amortisation, or EBITDA, is an alternative metric to net income for determining profitability. EBITDA aims to reflect the cash profit produced by the company's activities by eliminating non-cash depreciation and amortisation expenditure, taxes, and debt expenses based on the capital structure.

2. The interest coverage ratio uses earnings before interest and taxes, or (EBIAT)

As opposed to earnings before interest and taxes, EBIAT demands that tax liabilities be subtracted from the numerator. The EBIAT technique thus offers a more accurate depiction of a company's ability to pay interest fees. 

Tax responsibilities are both necessary to pay. Many firms have comparatively high tax liabilities as a result of their tax structure. As a result, it seems acceptable to subtract it. This approach may be used to determine interest coverage ratios using EBIAT instead of EBIT. Like EBITDA, EBIAT provides a more precise representation of a company's capacity to pay its interest cost. 

Limitations of the Interest Coverage Ratio

Even though the Interest Coverage Ratio (ICR) is a helpful indicator for determining a company's capacity to pay interest payments, there are several restrictions that need to be taken into account:

1. The ICR simply considers a company's capacity to pay interest costs. Other debts like principal repayments, lease payments, or profits are not taken into account. 

2. Differences in a company's capital structure or debt maturity are not taken into consideration by the ICR. Even if their ICR looks to be robust in the short term, companies with a larger share of debt or a shorter loan maturity may face higher refinancing risks.

3. Non-recurring events, such as one-time gains or losses, restructuring costs, or lawsuit settlements, might have an effect on the ICR. 

4. The ICR displays a company's financial standing at a certain period. It excludes the possibility of future earnings, interest rates, or market conditions of a firm changing. 

What is the Interest Coverage Ratio Formula?

The ratio is calculated by dividing EBIT (or any variation thereof) by interest on debt charges, which represents the cost of borrowing money over a specified period of time, often a year.

The following is the interest coverage ratio formula:

EBIT / Interest Expense = the interest coverage ratio

Conclusion

To sum up, the Interest Coverage Ratio (ICR) is a financial indicator used to evaluate a company's capacity to fulfil its commitment to pay interest. It is a crucial gauge of a company's financial health and stability since it shows how often earnings can pay interest costs. 

The ICR gives information on a company's ability to control its debt and interest payments. It will help to maximise the benefits of the measure and more successfully address its shortcomings. Before making an investment in or lending money to a certain firm, one should also take other factors into account. Moreover, if you wish to invest in stocks you can check blinkX stock trading app. It functions as the appropriate trading app for all investor profiles because it is a trading platform with the most recent features and tools.

Interest Coverage Ratio FAQs

The amount of times a company's earnings can cover its interest expenditures is the interest coverage ratio. Better financial health and a stronger capacity to pay interest commitments are indicated by higher ratios.

A decent interest coverage ratio varies by industry and the unique conditions of the organisation. A ratio above 2 is often seen as adequate, meaning the business makes enough money to pay its interest costs. 

If the interest coverage ratio is less than 1, it means that the company's earnings are insufficient to cover its interest expenses. 

Yes, there are restrictions on the interest coverage ratio. It does not take into account other financial commitments or elements like principal repayments, lease payments, or profits and just concentrates on interest expenditures.

Yes, you may compare businesses in the same sector or industry using the interest coverage ratio.