What is the Interest Coverage Ratio?

The Interest Coverage Ratio (ICR) is a ratio used in financial analysis to measure a firm’s capacity to service interest payments on existing debts by using operating earnings. The Interest Coverage Ratio is an indicator of the number of times that a firm’s earnings are able to pay for its interest costs.

A high Interest Coverage Ratio reflects a firm that is better positioned to cover its interest payments and is less likely to be under financial stress because of debt. A low Interest Coverage Ratio could mean that more of the firm’s earnings are being used up in servicing its interest costs.

Interest Coverage Ratio Formula

In this case, EBIT (Earnings Before Interest and Taxes) represents the earnings before the deduction of interest and taxes, while the interest expense represents the total amount of interest payable on debt.

For a retail firm, there is:

EBIT = $300,000

Interest expense = $30,000

ICR = $300,000 ÷ $30,000 = 10

An ICR of 10 means the firm’s EBIT is 10 times its annual interest expense. In other words, the company generates $10 of operating earnings for every $1 it owes in interest.

Is the Interest Coverage Ratio the Same as the Interest Burden Ratio?

It may not always be so. The term “interest burden ratio” could actually mean other things depending on the specific circumstances. The common Interest Coverage Ratio is calculated based on the relationship between EBIT and interest expenses as follows:

ICR = EBIT ÷ Interest Expense

Importance of ICR

• ICR is used by the lenders to set the pricing and structure of their debt. The lower the ICR, the higher the interest rates charged or stricter the covenants imposed, or the fewer future borrowing opportunities available.
• This is a very common loan covenant. Most of the credit agreements contain a required ICR that the debtor needs to maintain; otherwise, even though the debtor is making timely payments, it will still be considered a covenant breach.
• Early warning signal. ICR starts declining before the company fails to make any of its payments.
• Financial risk measure for investors. The company may be generating revenue at a fast pace, but a low ICR might be exposing itself to more risks from its debt than its earnings can support.

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