How to Calculate and Use the Interest Coverage Ratio

Jun 8, 2023

how to calculate interest coverage ratio

For established companies in certain industries, such as a utility company, an interest coverage ratio of two is often an acceptable standard. Staying above water with interest payments is a critical and ongoing concern for any company. As soon as a company struggles with its obligations, it may have to borrow further or dip into its cash reserve, which is much better used to invest in capital assets or for emergencies. Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics. Specialties include general financial planning, career development, lending, retirement, tax preparation, and credit.

What is the Formula for Interest Coverage Ratio?

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Interpretation of Interest Coverage Ratio

The interest coverage ratio is used to determine a company’s ability to meet its interest expense obligations with its operating income. The interest coverage ratio is a financial metric that measures whether companies can pay their outstanding debts. The consignment sale definition general rule is that the higher the ratio, the better position a company has to repay its interest obligations while lower ratios point to financial instability. Analysts generally look for ratios of at least two (2) while three (3) or more is preferred.

  1. There are several ways a company can improve its ICR, including reducing its level of debt, increasing its earnings, and negotiating lower interest rates on its debt.
  2. On the flip side, a higher interest coverage ratio signals a lower risk of bankruptcy or default.
  3. The formula to calculate the interest coverage ratio involves dividing a company’s operating cash flow metric – as mentioned earlier – by the interest expense burden.

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Knowing how to calculate it and using it with other valuable financial metrics can help you become a well-informed investor so you can make better decisions about your investments. A company’s interest coverage ratio is an indicator of its financial health and well-being. Coverage refers to the length of time—ordinarily the number of fiscal years—for which interest payments can be made with the company’s currently available earnings. The interest coverage ratio is sometimes called the times interest earned (TIE) ratio. Lenders, investors, and creditors often use this formula to determine a company’s riskiness relative to its current debt or for future borrowing.

how to calculate interest coverage ratio

Interest Coverage Ratio Formula

Companies need to have more than enough earnings to cover interest payments in order to survive future and perhaps unforeseeable financial hardships that may arise. A company’s ability to meet its interest obligations is an aspect of its solvency and is thus an important factor in the return for shareholders. First, they can track accounts receivable and accounts payable changes in the company’s debt situation over time. In cases where the debt-service coverage ratio is barely within the acceptable range, it may be a good idea to look at the company’s recent history. If the ratio has been gradually declining, it may only be a matter of time before it falls below the recommended figure.

When evaluating a company’s financial stability, lenders, investors, and stakeholders often look at various financial ratios. The Interest Coverage Ratio, also known as the Times Interest Earned Ratio, is one such ratio that provides insights into a company’s ability to fulfill its interest payment obligations. Interest Coverage Ratio is a financial metric that helps assess a company’s ability to meet its interest payment obligations on its outstanding debt.

The Interest Coverage Ratio provides valuable insights into a company’s ability to meet interest payments, highlighting its financial health and risk profile. By assessing the ratio in conjunction with other financial indicators, lenders and investors can make informed decisions. Regular monitoring and analysis of the Interest Coverage Ratio help companies proactively manage their financial obligations and work towards improving their overall financial stability. Operating income is sometimes referred to as earnings before interest and taxes (EBIT).

The interpretation of the Interest Coverage Ratio varies across industries. A ratio below 1 suggests that a company’s earnings are insufficient to cover its interest payments, indicating financial distress and a higher risk of default. Alternatively, assume ABC Company had only $20,000 in operating income, its interest coverage ratio would be 2.0. The ratio is lower than the standard of 3.0, which would indicate to analysts that ABC may have trouble paying its interest expense obligations on its current operating income. The use of earnings before interest and taxes (EBIT) also has its shortcomings, because companies do pay taxes. To account for this, you can take the company’s earnings before interest (but after taxes) and divide it by the interest expense.

However, EBIT is not an approved financial measure by Generally Accepted Accounting Principles (GAAP)– it is not allowed on an income statement. Operating income does appear on the income statement, so it is an easier figure to identify and calculate the interest coverage ratio. There may be slight differences between operating income and EBIT because EBIT includes interest income while operating income excludes it. Many metrics can help you determine the financial health and well-being of companies and, therefore, your investment portfolio. This figure measures a company’s ability to cover its interest obligations.