What Does ‘Interest Coverage Ratio’ Mean?

What Is an Interest Coverage Ratio?

The interest coverage ratio (ICR) is a financial metric used to measure a company’s ability to pay its interest expenses on its debt. It calculates the number of times a company’s EBIT (Earnings Before Interest and Taxes) covers its interest expense for a given period. Typically, lenders look for companies with an ICR higher than 1.5 as this is a sign of financial health and an indication that the company will be able to meet its interest obligations.

How to Calculate Interest Coverage Ratio

The interest coverage ratio formula is calculated by dividing a company’s EBIT (Earnings Before Interest and Taxes) by its Interest Expense. Here is the equation:

Interest Coverage = EBIT / Interest Expense

For example, let’s say a company has earned $100,000 in EBIT (Earnings Before Interest and Taxes) in a 12-month period and its Interest Expense is $30,000. We would calculate the ICR like this:

Interest Coverage = $100,000 / $30,000 = 3.33

This means the company’s interest coverage ratio (ICR) is 3.33, which is well above the 1.5 threshold lenders typically look for.

Why Is the Interest Coverage Ratio Important?

The interest coverage ratio is an important metric for investors and lenders to analyze when evaluating a company’s financial health and stability. A higher ICR indicates that a company has a greater ability to pay its existing debt obligations and may be seen as a more attractive investment or lending opportunity. If a company’s ICR is below 1.5, it may indicate the company is in financial distress and could be at risk of defaulting on its debt obligations.

Conclusion

The interest coverage ratio is a metric used to measure a company’s ability to pay its interest expenses on its debt. It is an important indicator of a company’s financial health and stability and should be closely monitored by investors and lenders when evaluating potential investments or lending opportunities. A higher interest coverage ratio indicates a company’s financial health and could be seen as a more attractive investment or lending opportunity.