Formula & Calculation | Examples & Explanation | What's Good & Bad

Emilie N.- FCCA, CB, MBS

Emilie is a Certified Accountant and Banker with Master's in Business and 15 years of experience in finance and accounting from corporates, financial services firms - and fast growing start-ups.

Contents

The **higher** the ratio, the **better** positioned a company is to **service** its **debt**:

- High ICR means that a company would be able to pay off its interest expense out of earnings multiple times.
- Low ICR signals that the company may not be able to meet its interest payment obligations on debt.

In other words, the interest coverage ratio shows whether a company is generating enough profits to **easily** pay for its interest charges–or if the debt burden with the associated finance costs is **too high** compared to the size of the company’s profits.

The interest cover ratio measures the **margin of safety**:

How far can earnings of a company decline before it starts defaulting on its debt payments?

These are the **3 major financial risks** typically highlighted by a low interest cover:

Low Interest Cover = Higher Financial Risk | |
---|---|

Risk #1: Solvency | Profit may become insufficient to meet debt interest payment commitments when they fall due, which could eventually force the entity into liquidation. |

Risk #2: Financing | Borrowing may become more expensive or even entirely unavailable, which limits the growth of a company. |

Risk #3: Dividends | Limited or no residual distributable profits left over for dividends to ordinary shareholders. |

Conversely, **higher** interest **cover** represents **lower** financial **risk** associated with debt, leverage and gearing–resulting in better liquidity, solvency and overall financial stability.

Interest Cover | Financial Risk |
---|---|

Low | High |

High | Low |

As a result, the interest coverage ratio is often used by lenders and other creditors, as well as shareholders and other investors, to determine the risk associated with providing funds to a company.

**Creditors**are primarily concerned with the risk of default on debt**Investors**are interested in the probability of growth and return on investment

**Interest Coverage Ratio = Operating Profit / Debt Interest **

Where:

**Operating Profit**= EBIT (Earnings Before Interest and Tax) or PBIT (Profit Before Interest and Tax)**Debt Interest**= Finance cost of debt represented by the interest expense payable on any borrowings (e.g., loan, line of credit, bonds)- Preference dividends are usually excluded from interest.

The ICR formula can be used to calculate the ratio for any period of time, such as a month, quarter or year.

However, always make sure that the profit and interest time periods match. For example, you may need to convert monthly interest payments into a quarterly or annual charge.

The result of the ICR calculation is usually expressed as a ratio “X:1”, “X times”, or just a number. For example:

- 3:1
- 3x
- 3 times
- 3.0
- 3
- Three

What is the interest cover of Company A and Company B? What implications does the ratio have for each company?

Financial Statements: Excerpt | Company A | Company B |
---|---|---|

PBIT (Profit before interest and tax) | $1,000,000 | $1,000,000 |

Interest | $100,000 | $666,000 |

PBT (Profit before tax) | $900,000 | $250,000 |

Taxation | $270,000 | $50,000 |

PAT (Net profit after tax) | $630,000 | $200,000 |

Compared to Company B (interest cover = 1.5x), Company A (interest cover = 10x) is in a much stronger position (almost 10x) in regards to the payment of interest charges on its debt:

Interest Cover: Example | Company A | Company B |
---|---|---|

PBIT divided by Interest | $1,000,000 / $100,000 | $1,000,000 / $666,000 |

Interest Coverage Ratio | 10 times (10:1) | 1.5 times (1.5:1) |

While Company A would be able to pay the interest on its outstanding debt **10 times** over, Company B could afford to fully cover its interest expense **only once**.

**Company A**has a larger financial cushion against any potential decrease in earnings or increase in interest rates. As a result, the profits of Company A would have to decrease considerably before it would even start having any issues covering the finance costs.

- In contrast,
**Company B**may be**vulnerable**to even a small temporary change in operating profits or interest rates, because its current earnings just about cover the interest payments on its debt.

What constitutes a “good” interest coverage ratio varies between industries–as well as among companies within the same industry.

“Good” Interest Coverage Ratio | ||
---|---|---|

Ratio | Interpretation | Financial Risk |

(Negative) to 1 | Sign of Insolvency = Interest > Profit | Entity is struggling to generate enough revenue to satisfy its interest expense on outstanding debt. |

1 to 2 | High Risk | Gearing is likely too high given the profitability of a company. Investors typically do not own anything below 1.5. |

2 to 3 | Acceptable Minimum | Generally, a ratio between 2-3 is regarded as an acceptable minimum. |

3 to 7 | Good | Investors and analysts often prefer to see a coverage ratio of 3 or above. |

7+ | Safe | An interest cover of more than 7 may be interpreted as safe. |

However, in practice, many companies operate successfully with interest coverage ratios on the lower end of the spectrum.

Some companies, business models and industries are more suitable for high-gearing than others.

For instance, large established corporations in stable mature industries often have significant borrowings resulting in low interest cover ratios. Yet, they are still able to pay off their regular interest payments on time–and even manage to keep borrowing more.

Suitability for High Gearing & Low Interest Coverage Ratio | ||
---|---|---|

Feature | High Gearing | Low Interest Cover | Low Gearing | High Interest Cover |

Profit | Stable | Erratic |

Assets | Suitable to pledge as security for borrowing purposes (e.g., buildings and land) | Fast depreciation with fluctuating demand and rapid changes in price (e.g., inventory) |

Example | Property, hotels, utilities | Manufacturing, high-tech, extraction |

Let’s demonstrate this in two examples:

- Example #1: Utilities

A typical utility provider (e.g., energy, water, waste) is a well-established company generating predictable revenues as a result of operating in a regulated environment with consistent demand and stable pricing.

As a result, utility companies can usually get away with a relatively low interest coverage ratio of 2.0 or even less.

- Example #2: Manufacturing

The manufacturing industry is more prone to fluctuations in demand and pricing.

Consequently, the minimum acceptable interest coverage ratio in manufacturing tends to be higher, generally 3.0 or above, to withstand the volatility and reliably cover interest payments even in periods of lower earnings.

Finally, some creditors and investors may be perfectly comfortable with a less desirable ratio–in exchange for a steeper interest rate charge, for example.

These are the **4 biggest reasons** why companies should keep their debt burden under control:

Interest on external borrowings must be paid in **all** circumstances, whether or not profits are earned. And a highly geared company has a **large proportion** of earnings to pay for interest charges.

Therefore, **low** interest coverage ratio increases the **financial risk** and the **probability of default** occurring through a company’s inability to finance its debts if, for instance, **earnings decrease** or **interest rates increase**.

In such situations, a company may not be able to meet the finance interest charges payable as they fall due out of the profits generated.

As we’ve already established, the **lower** the interest cover, the **greater** the **risk** that operating profit before interest and tax of a company will become **insufficient** to cover its interest payments.

If the borrowings are **secured** by any assets, then the debt holders are likely to force the company to **realize assets** to pay their interest if funds are not available from other sources.

In the worst case scenario, this might eventually lead to the **liquidation** of the company.

Being aware of these financial risks, banks and any other potential **lenders** may be **unwilling** put (more) money into a company that is heavily in debt, or at least make the financing very **expensive**.

Simply put, they do not fully **trust** in a company’s ability to **repay** the debt and interest.

That is why low-geared companies usually find it **easier** to borrow and so have more **flexibility** and scope to increase borrowings to **grow** their business.

Cost of both debt and equity financing increases with higher gearing.

Likewise, the** unavailability** and** cost of equity** financing increase with higher gearing.

From a shareholder perspective, lower interest cover may indicate higher degree of risk involved in holding equity shares in a company in terms of its ability to attribute and distribute earnings to the ordinary shareholders by the way of **dividend**.

Why?

This is simply because a company will not have any **residual profits** available for distribution to equity holders unless it is able to make enough profit before interest and tax to first pay the interest charges to the holders of **debt**, and then **tax** to the authorities.

In other words, the lower the profit or the higher the interest bearing debt, the less there will be left over for shareholders.

For example, if a highly-geared company makes only a modest profit before interest and tax, while carrying a heavy debt burden, very little–if any–profit will remain for shareholders after the payment of all debt financing charges.

Understandably, shareholders may be legitimately concerned that their dividends are at **risk** due to most **profits** being **eaten up by interest** payments.

Consequently, the **lower** the interest cover, the **higher** is the return required by shareholders to outweigh the financial risk.

Here’s the **twist**:

It may surprise you, but **both** low and **high** interest coverage ratios may cause issues.

Yes, generally speaking, a high level of interest cover is “good” because it shows there are enough profits available to service the debt.

*However:*

An interest coverage ratio that is **too high** may suggest that a company is **not borrowing enough**.

Since equity finance tends to be more **expensive** than debt, the company may not be **taking full advantage** of the opportunity to **maximize** earnings, growth and competitive advantage through leverage.

Calculating an interest coverage ratio for one time period is useful to provide a **snapshot** of the ability of a company to service debt at that particular **point in time**.

While assessing the **short-term financial health** of a company is beneficial, analyzing the ratio **over a longer period** of time will indicate the **long-term stability** of the company.

For example, if the ratio is showing a downward trend over time, it could suggest that the company may be unable to meet its debt obligations in the future. In which case, the debt position may need to be examined more closely, especially if the company is high-geared and the ratio is in the lower numbers.

Hence, it is advisable to track the ICR as a timeline to analyze **trends over time**.

It is equally important to assess the ICR in the **context** of what is typical for the specific **business model** and company **size**, as well as the **industry** the company operates in.

This is because interest coverage varies widely when measuring entities within different industries and even when comparing entities within the same industry.

*Did you know? >>*

There are industry benchmarking tools available online, using governmental and/or private data, where you can find average values for interest cover across different industries.

Movements in **interest rates** on regional and national level play a big role in a company’s interest coverage ratio.

The ratio is also affected by the overall state of the economy, such as a **recession** or an economic **boom**.

Similarly, many businesses are **cyclical** in nature, in which case **seasonality** should be taken onto account when assessing interest cover and financial risk.

When analysing the ICR of a company, remember to carefully read the **notes** to the company’s financial statements–and adjust your calculations accordingly for anything that could skew your numbers.

For example:

- Company may be able to defer interest payments as allowed by some creditors
- Company may accrue an interest expense that is not yet due for payment
- Company may choose to exclude certain types of debt from a self-published ICR calculation

And most importantly, the interest coverage ratio must be evaluated **in combination** with other **financial** and** non-financial** metrics and information to arrive at a more **complete** risk profile of a company.

Considering the two elements that go into calculating the ratio–Operating Profit and Debt Interest–the interest cover could be improved in **two** main ways:

- 1. Increase earnings before interest and tax through, for example, generating more revenue and/or managing costs better.
- 2. Decrease finance costs through, for instance, reducing the level of debt and/or lowering financing costs (e.g., switch providers to receive a more favourable rate)

There are two main variations of the interest coverage ratio, both of which use interest in the denominator. The variation comes from alternating EBIT/PBIT in the **numerator** with **EBITDA** or **EBIAT**.

In terms of conservatism, ICR using **EBITDA** is the most **liberal** measure of interest cover, **EBIT** is more **conservative**, while EBIAT is the most stringent.

ICR Numerator | Level of Conservatism |
---|---|

EBITDA | Low |

EBIT | Medium |

EBIAT | High |

One alternative variation of the interest cover formula is using EBITDA (Earnings Before Interest, Taxes, **Depreciation and Amortization**) as the numerator:

*EBITDA* Interest Coverage Ratio = **EBITDA** / Debt Interest

Compared to using the standard EBIT as the numerator, the EBITDA calculation will always produce a **higher** ICR ratio. This is because the numerator excludes depreciation and amortization, while the interest expense denominator remains unchanged.

Taxation is an important part of a company’s overall financial situation, affecting its ability to cover interest expenses.

Hence, one of the **criticisms** of the standard ICR ratio is that by using PBIT/EBIT the calculation does not take into account the tax obligations of an entity.

In order to provide a more accurate picture of a company’s ability to meet its finance costs, another variation of the ICR formula **deducts tax** expenses **from** the **numerator**, using Profit Before Interest **After Tax** (PBI**A**T / EBI**A**T) instead of PBIT/EBIT.

*EBIAT* Interest Coverage Ratio = **EBIAT** / Debt Interest

It then logically follows that the calculation using EBIAT generates a **smaller** ICR ratio than the standard EBIT formula.

While the interest coverage ratio is often used in the context of companies, you can easily apply the metric to yourself in 2 steps:

- Step 1: Combine the interest expenses from your credit card debt, mortgage and any loans you may have (e.g., car loan, student loan) and any other debt obligations.
- Step 2: Calculate the number of times the expense can be paid with your annual pre-tax income.

Generally speaking, the higher your interest coverage ratio, the lower the possibility of default or bankruptcy–and vice versa.

The interest coverage ratio is the **inverse** form of the reciprocal **interest-to-profit ratio**, also known as the **interest gearing ratio**.

The interest gearing ratio represents the percentage of the operating profit absorbed by interest charges on borrowings and as a result measures the impact of gearing on profits.

Difference: Interest Gearing vs. Interest Coverage Ratio | |
---|---|

Interest GEARING Ratio | Debt Interest / Operating Profit |

Interest COVERAGE Ratio | Operating Profit / Debt Interest |

In addition to the interest cover, there are two other leverage ratios that are definitely worth looking into when measuring the financial risk associated with a company’s gearing: the **gearing ratio** and a **debt ratio**.

Emilie N., FCCA, CB, MBS

Emilie is a Certified Accountant and Banker with Master's in Business and 15 years of experience in finance and accounting from large corporates and banks, as well as fast-growing start-ups.

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