What is the Interest Coverage Ratio (ICR)? The ICR gauges a firm’s ability to cope with its outstanding debt. It is one of several debt ratios that can help to evaluate a business’s financial condition. A firm cannot survive unless it can pay the interest on its existing obligations to creditors. Hence, a good ICR is considered necessary by both market analysts and investors.
It is indeed very interesting what the Interest Coverage Ratio Means. The term “coverage” refers to the length of time for which interest payments can be paid with the firm’s currency available earnings. It shows how many times the firm can pay its obligations with its earnings, to put it another way.
Furthermore, the interesting question is how to calculate the Interest Coverage Ratio. To calculate the Ratio, we should divide earnings before interest and taxes (which is called EBIT) by the total interest expense on all of the firm’s outstanding debts. Significantly, a firm’s debt can include lines of credit, loans, and bonds. We can also use this formula to calculate the Ratio for any interest period, including monthly or annually.
For instance, imagine a firm’s earnings before taxes and interest equal $50,000, and its total interest payment requirements amount to $25,000. To calculate the Ratio, we should divide $50,000 by $25,000, and it equals 2.
However, suppose a business has a low ICR. In that case, there is a greater likelihood the firm will not pay its debt. To put it another way, a low-ICR suggests a low amount of profits available to pay the interest expense on the debt.
Furthermore, if the firm has variable-rate debt, the interest expense will grow in a growing interest rate environment.
A ratio below 1 means a firm cannot pay its interest payment obligations
Notably, a high ratio means there are enough profits available to pay the debt. However, it may also indicate the firm is not using its dept properly. For instance, if a firm is not borrowing enough, it may not be investing in new products and technologies. It means the company will not stay ahead of the competition in the long term.
What creates good interest coverage changes between industries and between companies in the same industry. Usually, the coverage ratio of at least two is viewed as the minimum acceptable amount for a business that has solid, consistent revenues. However, it is essential to mention that analysts prefer to see a three or better coverage ratio. A coverage ratio below one means a firm cannot pay its current interest payment obligations and, hence, is not in good financial condition.
A firm’s likelihood to continue to meet its interest expenses is uncertain if an ICR is below 1.5. Especially if the business is vulnerable to seasonal or cyclical dips in income.
The ICR an important not only for creditors but also for shareholders and investors. Creditors need to know if a company will be capable of paying back its debt. If the business has trouble doing so, there is less possibility that future creditors will want to extend any credit.
Furthermore, both shareholders and investors can also use this Ratio to make decisions about their investments. A firm that cannot pay back its debt suggests it will not develop. Most investors may not be willing to put their money into a business that is not financially stable.