The interest coverage ratio is a measure that indicates how many times the business’ Earnings before Interest and Expenses (EBIT) cover the company’s interest expenses. The Interest Coverage Ratio is a debt ratio, as it tracks the business’ capacity to fulfill the interest portion of its financial commitments.
What is the Interest Coverage Ratio?
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Lenders and bondholders are especially interested in tracking the Interest Coverage Ratio of companies as it allows them to determine the business’ capacity to fulfill its interest payments. Particularly, bondholders, who are entitled to receive coupon payments, can feel assured that their coupons will be paid as promise if the company has a high Interest Coverage Ratio.
Additionally, businesses who are looking for funding will be assessed based on their payment capacity, which includes an evaluation of cash flow, interest coverage, total debt coverage and other key metrics that provide a clear picture on their current situation and capacity to undertake new financial commitments.
A company with outstanding bond issues has to be careful to maintain a high interest coverage ratio. If the ratio declines, the bond’s credit rating will probably be downgraded, which will reduce the price of the bond, as the risk of a potential default perceived by the market will be significantly higher.
Interest Coverage Ratio Formula
The interest coverage ratio formula is calculated like this:
ICR = EBIT / Interest Expenses
Interest Coverage Equation Components
EBIT: Earnings before Interest & Taxes.
Interest Expenses: The total amount of interest that the company paid throughout a year.
The result of the metric is the number of times the Earnings before Interest & Taxes cover the entire interest expenses.
Interest Coverage Example
Cookies n’ Stuff is a company with a large number of stores and franchises spread across the United States where they sell cookies, coffee, muffins, brownies and other desserts to their loyal customers. The brand has made a name of itself and combined, the stores sell more than $1.2 billion a year.
A potential investor is currently analyzing the business’ financials to invest in one of the bond series the company issued 2 years ago. The bond offers a 6.3% interest rate paid quarterly and it is currently price at $32 with a par value of $100. This low price doesn’t seem consistent for a company that has position itself as an industry leader, therefore the investor decided to look into the numbers deeply to understand why.
Last year, the company’s Earnings before Interest and Taxes added up to $112 million and the business’ interest expenses were $76 million. According to this information, the Interest Coverage Ratio for Cookies n’ Stuff is:
ICR = $112,000,000 / $76,000,000 = 1.5 times.
A coverage that low is a risky situation to be in for a business like Cookies n’ Stuff. This situation has been the main cause why the price of the bonds has decreased dramatically in the last 2 years, as the business appears to be in a weak position to cover for its interest expenses.
Interest Coverage Ratio Analysis
The Interest Coverage Ratio is an essential metric that aims to illustrate how healthy a company is when it comes to fulfilling its current financial commitments. Companies with a large debt incur in substantial interest expenses, since these expenses have to be paid by the revenues generated by the business, if the business performs poorer than expected, the company’s ability to fulfill its interest expenses is affected.
Even though the company may be financially sound in its Balance Sheet, the company’s credit rating will be affected by a low ICR ratio. The reason why the ratio may be low could be due to a sales downturn, an excessive interest rate on the debt or even a poor administration. In any case, a healthy Interest Coverage Ratio is usually above 3.
Also, the ICR is also employed as one of the key metrics that are examined to determine the interest rate that will be set by lenders to issue a loan on behalf of the company. If a company’s ICR is low, financial institutions tend to increase the interest rate to compensate for the risk of a potential default.
While there’s no standard Interest Coverage Rate that may be indicated for all companies, most industries have a certain minimum that they see advisable for the businesses that participate in it, as historically, businesses with a lower ratio than that have gone into trouble.
Other important debt ratios include the Debt-to-Assets ratio, that measures the percentage of a business’ total assets that are financed through debt; the Debt Service ratio, which measures the coverage of all debt-related payments that are due in the next 12 months; and also the Fixed Charges Coverage Ratio, which measures the number of times a business’ fixed charges including leases, insurance premiums and other similar expenses.
Analyzing these metrics will provide a fairly accurate picture of how leveraged a business is and what is current payment capacity is, in order to properly value its debt and decide if it would be advisable to invest on its bonds or to extend a loan.
Interest Coverage Ratio Uses, Cautions, Pitfalls
While the Interest Coverage Ratio seems as a fairly straightforward metric, the adequate estimation of a business annual interest charges is the key to understand the actual financial situation of the company.
Depending on the terms established on the business’ debt, investors and analyst must look carefully into how interest charges are paid on the outstanding debt, to make sure the Interest Coverage ratio is accurate. Some loans may offer a business the possibility to defer interest payments for a year or sometimes even more. During this period, if the ICR is calculated by using the interest expenses paid during the year, the ratio will be overestimated and therefore it will paint a distorted picture of the business actual capacity to fulfill its commitment.
In order to avoid this, analyst should forecast the interest payments for the next 5 years according to the terms and conditions established by the lenders and commonly disclosed on the notes that accompany the financial statements of the company. This way, a more accurate picture of how interest charges will look like in the future can be painted, and therefore, the analyst can create a more accurate analysis of the actual situation.