Interest Coverage Ratio
How do you know what companies are safe to invest in?
Is it just a matter of picking the right industries, or is it about the right company within those industries? Apparently, a critical factor that can help you determine a company’s health and growth potential is its interest coverage ratio.
And one easy way to figure out this ratio is by using our Calcopolis Interest Coverage Ratio Calculator. It’s a powerful tool for small business owners and investors alike that can help you make better decisions about your finances.
So today, we’ll introduce you to the formula behind this fantastic tool and discuss how interest coverage ratio can help you make better choices.
What Is the Interest Coverage Ratio?
The ICR (interest coverage ratio) is a metric that helps investors and market analysts determine how efficiently a company can pay its outstanding debts before taxes and interest. Also, the interest coverage ratio is sometimes referred to as TIE (times interest earned).
It’s one of the many vital debt and profitability ratios for investors, banks, and lenders because it can help predict whether a company will go bankrupt in the future or not.
How to Calculate the Interest Coverage Ratio?
First and foremost, you need to know that the interest coverage ratio measures how long a company takes to pay off its debts. That’s what “coverage” stands for—the length of time.
It could be yearly or quarterly, depending on the company’s goals and financial health. Now, to use the formula to calculate the ratio, you’ll need to know the following:
- The company’s earnings before interest and taxes (EBIT), which you can usually find in its annual income statement. If you couldn’t find it, the operating income might serve as a substitute.
- The interest expense (IE), which you can also find in the income statement
Interest Coverage Ratio Formula
Then, our Calcopolis calculator uses this formula to get the ICR:
Interest Coverage Ratio = Earnings before interest and taxes (EBIT) ÷ Interest Expense
So, for instance, if you’ve got a company with an EBIT of $50 million and an IE of $40 million, the ICR would be:
ICR = 50,000,000 ÷ 40,000,00 = 1.25x
Sadly for this imaginary company, this is considered a lousy ratio that might make investors turn their backs. A good ratio is generally around 1.5 or more.
Anything less than that means that there’s a significant risk of bankruptcy.
The Importance of Interest Coverage Ratio
One of the reasons that the interest coverage ratio is such a valuable analysis tool is that it allows you to look at both debt and profitability ratios.
For instance, as we mentioned in our earlier example, a company with an ICR of 1.5 or lower is at risk of going insolvent in the near future.
It might resort to taking out more loans, making it susceptible to becoming more leveraged and, therefore, riskier for lenders to provide new loans.
Of course, this can be hard to accomplish, especially since investors and lenders will label it as a risky company. On the other hand, if the ICR is higher than 1.5, it means that the company’s earnings are sufficient enough to cover its interest payments.
Furthermore, suppose you follow a business’ annual report and notice a steady increase in the ICR until it reaches more than 3 or 4.
In that case, you can rest assured that the company is generating an adequate amount of cash to maintain plenty of future profit with low debt levels.
How Can This Metric Help You Make Better Decisions?
Knowing the interest coverage ratio can help you tremendously as an investor or a business owner.
For example, it’s a great way to measure the financial health of your company or investments, as well as see if you should be worried about future debt payments.
It can also help you determine when it may be time to sell an asset that isn’t performing well or has become too expensive to maintain.
Moreover, you can use the ICR to compare various companies to figure out which ones are worth investing in. Finally, if you’d like, you can take it a step further and compare different industries and sectors to determine the best investments.
How to Increase Your Interest Coverage Ratio?
Sitting down and seeing your company’s ICR getting closer and closer to the 1.5 mark can be a stressful experience. It’s a sign that the company is getting less stable, and you need to take action.
So, here are two things you could do to save the company:
- Improve the EBIT (earnings before interest and tax) by increasing revenue
- Reduce your finance costs by decreasing your debt levels
Created by Lucas Krysiak on 2023-02-16 16:50:34 | Last review by Mike Kozminsky on 2023-02-16 17:01:02