Interest Coverage Ratio: Formula, How It Works, and Example

What is interest coverage ratio

Walmart’s Annual Report, Form 10-K for the year ended January 31, 2023, included this consolidated income statement. The company presents its operating income and net interest expense on the financial statement. The net interest expense is the combination of its interest income– interest it has earned from investors– and its interest expense– amounts it has paid to lenders. 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. The lower the interest coverage ratio, the greater the company’s debt and the possibility of bankruptcy.

  • The ICR is commonly used by lenders, creditors, and investors to determine the riskiness of lending capital to a company.
  • 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.
  • When the interest coverage ratio is smaller than one, the company is not generating enough cash from its operations EBIT to meet its interest obligations.
  • Besides the mandatory repayment of the original debt principal by the date of maturity, the borrower must also service its interest expense payments on schedule to avoid defaulting.

The interest coverage ratio is calculated by dividing a company’s earnings before interest and taxes (known as EBIT) by its interest expense over a given accounting period. Building a cash flow statement from scratch using a company income statement and balance sheet is one of the most fundamental finance exercises commonly used to test interns and full-time professionals at elite level finance firms. On the other hand, an interest coverage ratio of more than 3.0 indicates that the company is able to pay its accumulated interest with its current operating income.

Formula and Calculation of the Interest Coverage Ratio

Thomas’ experience gives him expertise in a variety of areas including investments, retirement, insurance, and financial planning.

The Interest Coverage Ratio measures a company’s ability to meet required interest expense payments related to its outstanding debt obligations on time. A good interest coverage ratio is considered important by both market analysts and investors, since a company cannot grow—and may not even be able to survive—unless it can pay the interest on its existing obligations to creditors. A ratio above one indicates that a company can service the interest on its debts using its earnings or has shown the ability to maintain revenues at a fairly consistent level. While an interest coverage ratio of 1.5 may be the minimum acceptable level, two or better is preferred for analysts and investors.

What is the Formula for Interest Coverage Ratio?

The debt service coverage ratio (DSCR) evaluates a company’s ability to use its operating income to repay its debt obligations including interest. The DSCR is often calculated when a company takes a loan from a bank, financial institution, or another loan provider. For example, a DSCR of 0.9 means that there is only enough net operating income to cover 90% of annual debt and interest payments.

What is interest coverage ratio

It is one of a number of debt ratios that can be used to evaluate a company’s financial condition. The term “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. In simpler terms, it represents how many times the company can pay its obligations using its earnings. The interest coverage ratio (ICR), also called the “times interest earned”, evaluates the number of times a company is able to pay the interest expenses on its debt with its operating income. As a general benchmark, an interest coverage ratio of 1.5 is considered the minimum acceptable ratio. An ICR below 1.5 may signal default risk and the refusal of lenders to lend more money to the company.

What Is the Interest Coverage Ratio?

When a company’s interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable. Therefore, the company would be able to pay its interest payment 8.3x over with its operating income. Interest coverage is subjective as some lenders, investors, or banks may be okay with lower ratios. Yet while the interest coverage ratio is useful in isolation it should be analyzed,  just like many other financial KPIs, over time (as opposed to in isolation). This allows for a more holistic understanding of a business’ trajectory and financial health.

For companies with historically more volatile revenues, the interest coverage ratio may not be considered good unless it is well above three. The “coverage” in the interest coverage ratio stands for the length of time—typically the number of quarters or fiscal years—for which interest payments can be made with the company’s currently available earnings. The interest coverage ratio is a debt and profitability ratio used to determine how easily a company can pay interest on its outstanding debt. The interest coverage ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expense during a given period. A Coverage Ratio is any one of a group of financial ratios used to measure a company’s ability to pay its financial obligations.

#2 Debt Service Coverage Ratio

The company may be forced to find other sources, such as retained earnings from prior years, to cover interest expenses. It does not bode well for the company’s ability to meet its financial obligations and continue in existence. 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. Another variation uses earnings before interest after taxes (EBIAT) instead of EBIT in interest coverage ratio calculations. This has the effect of deducting tax expenses from the numerator in an attempt to render a more accurate picture of a company’s ability to pay its interest expenses.

Income Statement Financial Forecast

A company with very large current earnings beyond the amount required to make interest payments on its debt has a larger financial cushion against a temporary downturn in revenues. A company barely able to meet its interest obligations with current earnings is in a very precarious financial position, as even a slight, temporary dip in revenue may render it financially insolvent. A bad interest coverage ratio is any number below one as this means that the company’s current earnings are insufficient to service its outstanding debt. The ratio is calculated by dividing EBIT (or some variation thereof) by interest on debt expenses (the cost of borrowed funding) during a given period, usually annually. Regardless of the type of calculation you run, another important consideration is that interest coverage varies tremendously by industry, and even between companies. Acceptable standards change accordingly, so take the figure only within a given context.

Free Accounting Courses

A higher ratio indicates a greater ability of the company to meet its financial obligations while a lower ratio indicates a lesser ability. Coverage ratios are commonly used by creditors and lenders to determine the financial standing of a prospective borrower. In contrast to leverage ratios, coverage ratios compare a cash flow metric that captures the company’s operating cash flow in the numerator to the amount of interest expense on the denominator. Many metrics can help you determine the financial health and well-being of companies and, therefore, your investment portfolio. 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.

Leave a Reply

Your email address will not be published. Required fields are marked *