What is interest coverage ratio?
As part of financial ratios analysis, Solvency ratios play an important role.
Interest Coverage Ratio (ICR) being an income statement ratio, indicates if the company has earned sufficient earnings so that it can make interest payments on the borrowings.
Interest coverage ratio meaning
An interest coverage ratio explains a company’s ability to earn profits to make interest payments on its borrowings.
Hence this ratio will be relevant only in the case of the companies having borrowings as part of their business.
Often used as a covenant, lenders rely heavily on this ratio as it helps lenders in evaluating if the companies are making profits to cover the interest expenses.
Hence, companies with borrowings on the balance sheet focus constantly on maintaining a high coverage ratio.
Interest coverage ratio formula
The formula for the ICR is simple.
It can be calculated taking values from Income Statement.
We take EBIT in the numerator and interest expense in the denominator.
EBIT stands for Earnings before interest and taxes.
Interest expense is the money paid by the company to the lenders on borrowings.
Sometimes, earnings before interest, taxes and depreciation and amortization (EBITDA) is also used in the numerator (we will discuss in our examples later)
Let us understand the formula with a hypothetical example taking two companies.
Interest coverage ratio example using EBIT
Let us look at our 1st example.
Both Company A and Company B has
- Borrowings of 200 million
- Interest rate of 10% pa
- Hence annual interest expenses will be 20 million.
Also, below is the profitability profile for both the companies.
Although both the companies have the same borrowings and interest rate profiles, their EBIT profile differs.
Let us calculate the interest coverage ratio for both the companies using EBIT in this example.
We will use the below-given interest coverage ratio formula.
EBIT = 60 million
Interest cost = 20 million.
Dividing 60 million by 20 million we get interest coverage ratio of 3 x
EBIT = 40 million
Interest cost = 20 million.
Dividing 40 million by 20 million we get interest coverage ratio of 2 x
What this means is that Company A was able to generate profit which is twice the interest expenses.
Generally higher the profits in terms of interest expense, better it is.
Let us move on to the next example.
Interest coverage ratio example using EBITDA
Alternatively, we can calculate the interest coverage ratio with slight modification i,e. instead of taking EBIT in the numerator we may use EBITDA ( Earnings before interest, taxes and depreciation and amortization) in the numerator.
The main reason why EBITDA may be considered instead of EBIT is that with EBITDA the earnings are not influenced by non-cash expenses such as depreciation and amortization expenses.
Hence EBITDA serves as better earnings metric than EBIT.
Now, let us look at the profitability profile for both the companies once again.
But, in this interest coverage ratio example, we will calculate using EBITDA in the numerator instead of EBIT.
Since we are taking EBITDA, non-cash expenses such as depreciation and amortization will not be included.
This results in better earnings metric in the numerator.
EBITDA = 70 million
Interest cost = 20 million.
Dividing 70 million by 20 million we get interest coverage ratio of 3.5 x
EBITDA = 50 million
Interest cost = 20 million.
Dividing 50 million by 20 million we get interest coverage ratio of 2.5 x
EBIT vs EBITDA
It is interesting to note that ICR for Company B when calculated with
- EBIT = 1.5 x
- EBITDA = 2.5 x
This is because depreciation and amortization expense in the case of company B is 20 million ( almost double of Company A) which lead to lower EBIT.
Hence, ICR must be calculated using EBITDA if the company is having significantly high depreciation and amortization expense. Else, generally, analysts uses EBIT in the numerator.
Interest coverage ratio for Walmart
In our example 3, let us calculate the interest coverage ratio for Walmart Inc using excel.
Download the interest coverage ratio template for Walmart using below option.
For the year ending 31 Jan, 2019,
EBIT = $ 21,957
Interest Expense = $2,129
ICR= $ 21,957 / $2,129 = 10.31
So, Walmart has a healthy ICR of 10.3 x .
In the same way, we can calculate ICR for Walmart for different years so that we can analyze the ratio in depth.
Interest coverage ratio interpretation
- As we have already understood, ICR indicates if the company has sufficient earnings to make its interest payment on borrowings.
- Generally, a high-interest coverage ratio is perceived as the company’s ability to make higher earnings relative to its interest expense. Here ICR> 1.
- Negative interest coverage ratio or Lower interest coverage ratio is seen as insufficient earnings to cover its interest expense. Here ICR <1.
- If ICR is lower or even negative, this leads to the default of interest payment on borrowings. Companies defaulting interest payment has a significant impact on its solvency.
- Lenders may stop continuing lending. If the situation worsens, companies may even have to file for bankruptcy.
- Interest coverage ratio would be relevant only in case of companies with borrowings on their balance sheet.
- Companies with nominal borrowings will typically have low-interest expense which leads to higher ICR.
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Any financial ratios will not give a clear picture when analyzed on a stand-alone basis. Hence trend analysis has to be performed for a particular ratio.
Let us look at how ICR has moved historically in the case of Walmart.
As you can see, ICR in the case of Amazon has increased significantly.
This indicates that the company was able to meet its interest expense quite easily.
Such an increase in interest coverage ratio would be possible either by increasing the EBIT or by reducing the interest burden.
In the case of Amazon, the company was able to generate a great amount of profits which easily helped it to meet its interest expense.
Hence, a thorough trend analysis of a financial ratio helps in understanding the company better.
Comparison with similar companies
It is also important to compare the Interest coverage ratio of the company with other similar companies in the same industry.
This helps in understanding if how is the company performing when compared to other competitor or industry as a whole.
Let us look at ICR profile for Home Depot – a home improvement retailer ( supplies tools, construction products, and various similar services )
Home Depot has higher ICR than compared with companies like Walmart.
But the ratio has been falling since 2015.
This is because the company raised money through borrowings which increased interest expense while the earnings did not increase sufficiently.
Hence the ratio has fallen from 21 x to 16 x.
Nonetheless, having such a high ICR is generally considered positive.
Amazon Inc is into e-commerce, cloud computing, digital streaming, and artificial intelligence and other similar business.
It is very interesting to note how Amazon has turned around amazingly.
The interest coverage ratio back in 2014 was as low as 1 x.
But, gradually the company was able to generate significant profits which increased ICR to 13 x. (See chart ! )
ExxonMobil is a US-based multinational oil and gas company. Generally, oil and gas companies are into highly capital intensive business.
They typically raise money through borrowings. Hence they have to bear interest expenses as part of their operations.
In this case, as well, ExxonMobil is able to earn only moderate profits so as to make interest payments. We can see that ICR for this company is in the range of 1 x to 2 x.
Generally, ICR of 1 x to 2 x is viewed cautiously. Because, if the profitability of the company deteriorates further, it may have to default on its interest payment which may lead to further woes.
Facebook, Google, and Microsoft
Although, not part of the chart shown above, tech companies like Facebook, Google ( Alphabet) and Microsoft do not have significant borrowings on their balance sheet.
In such cases, there will not be any interest expense burden on them. Accordingly, ICR for such companies will be nil or irrelevant.
Below are a few important aspects one must consider while analyzing any company using the interest overage ratio.
- EBIT or EBITDA: Depending upon how significant and volatile depreciation and amortization expense is, either EBIT or EBITDA should be taken in the numerator.
- Adjustments: If there are any non-recurring items while calculating EBIT or EBITDA, adjustments have to be made so as to get a true picture.
- Net Interest Expense: Companies sometimes receive interest income by parking its borrowings temporarily in banks. Such interest income has to be reduced from interest expense such that we arrive at Net interest expense.
Advantages of Interest coverage ratio
- The interest coverage ratio, being a solvency ratio help lenders and investors to know if the company is in a position to make its interest payments. It helps in identifying companies that are in deep interest expense burden and avoid investing in such companies.
- Another important advantage lies in its simplicity. Both numerator and denominator of the formula can be easily obtained from the income statement and generally does not require any major adjustments.
How to improve the interest coverage ratio?
There are various ways to increase ICR. Let us look at few of them.
Repayment of Borrowings
High borrowings on the balance sheet will be a drag to profitability because of interest expense.
If feasible, companies must re-pay their borrowings gradually which reduces interest burden in the future.
Negotiation of Interest Rate
Another ideal way to decrease ICR is to have control on interest expense.
This can be achieved by negotiating competitive interest rates from the lenders.
Often lower interest rates are enjoyed only by companies with sufficient credibility in the market.
Try to increase profits either by having strict control over the cost of production or by increasing sales price.
The appropriate strategy has to be deployed depending upon the market sentiments to achieve higher profits. This will invariably make ICR higher.
Scroll through below recommended resources or learn other important solvency ratios.