How To Calculate Interest Coverage Ratio?

Interest coverage ratio (ICR) or times interest earned ratio (TIE) are the same. The interest coverage ratio of a business or a company helps investors and lenders to calculate the risk of investing in them.

The calculation of the ICR helps someone decide the capability of a business to pay interest in the face of a strong debt. The higher the ICR, the easier it is for businesses to return interest from their available income.

But how to calculate the ICR of a business? If you are wondering about that, then this article will also help you. Here I have discussed the interest coverage ratio formula and have given examples of calculating the ICR.

What Is Interest Coverage Ratio?

The ICR of a company helps assess the debt and profitability ratio of a company. This ratio determines a company’s capability of paying off interest in the face of outstanding debt.

If you are thinking of future investments in a company this will come in handy. The calculation of the ICR is done by dividing the EBIT (earning of a company before interest and taxes) by the interest expense during a certain period. Companies with higher ICR have a better chance of paying interest on debt, while companies with lower ICR are often prone to bankruptcy.

Types Of Interest Coverage Ratios

There are different variations of the equation. But if you are studying the interest coverage ratio of a company, you need to consider two of these main variations. 

1. EBITDA

This calculation of the ICR excludes the depreciation and the amortization of the earnings. In this calculation, the ICR value is higher than the one you get by dividing EBIT by the interest expense.

2. EBIAT

In this calculation, the tax expense is deducted from the numerator to get a more accurate picture of the ICR value.

How To Calculate Interest Coverage Ratio?

So, if you want to calculate the ICR of a company before investing  ( and of course, find the right investments)then below is the formula that you need to follow –

Interest coverage ratio = (Earning before interests and taxes) / Interest expense

But before calculating the ICR, it is important to know each of the terms related to the calculation.

What Is EBIT?

When you want to calculate the ICR of a company, you should first calculate the EBIT. EBIT stands for Earning Before Interests & Taxes. It is a company’s net income before the tax, and the interest expenses are deducted from it.

The formula to calculate EBIT is –

What Is Interest Expense?

The interest expense is the payable interest of a business on any of the bonds, loans, credit or lines, etc.

Application Of The ICR Formula:

Let’s take an example so you will understand it better.

So, to calculate the ICR

ICR = EBIT/ Interest expense

Here, EBIT= $8,580,000

& Interest Expense = $3,000,000

So, ICR = $8,580,000 $3,000,000 = 2.86x

Thus, Company A can pay 2.86 times the interest payment along with the operating profit.

Benefits And Limitations Of Interest Coverage Ratio

Here are the benefits of ICR –

• The ICR of a company denotes its capability to pay off the debt in the face of outstanding debt interest expenses.  ICR of a company helps you notice a business out of debt, helping you make investment decision.
• The lenders, investors, and lenders can decide if they should put their money into a company by calculating the ICR.
• Another benefit of calculating the Interest coverage ratio is calculating the stability of a business.
• The short-term health of a company is also measured through the ICR.

Limitations Of Interest Coverage Ratio

Similar to most of the business measurement metrics, there are some limitations to using the ICR. here are some of the limitations worth knowing about –

• The ICR is variable across different industries. It can be variable in the same industry. The same ICR can be low for one business, which seems standard for another. The ICR value of a utility company is often considered standard.
• Many of the manufacturing industries often have a higher ICR value; some of them have an ICR value above three, and that is the minimum acceptable ratio.
• Companies may exclude or isolate specific types of debts when calculating their ICR. But it is important to take all the debts into account during the calculation.
• The most strict limitation is the difficulty of understanding and calculating EBIT. Due to this difficulty, the calculator of ICR is not as transparent as expected.

Frequently Asked Questions (FAQs):

Now that you understand what interest coverage ratio is and how to calculate it, some other questions might also appear to you. Here are some questions and answers as additional help –

Concluding Lines 

I hope that this article helped you calculate the interest coverage ratio of a company. Suppose you are struggling to calculate the ICR of any company. You need to follow the formula mentioned here. You should always remember to calculate the EBIT correctly before evaluating the ICR. 

For any queries, you can ask me in the comment section. Also, please let me know if you found this article helpful.

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