What is interest coverage ratio?

In today’s rapidly evolving business landscape, debt management and financial resilience are of utmost importance. The interest coverage ratio — often abbreviated as ICR ratio — is one of the important metrics used to gauge a company’s ability to meet its ongoing debt obligations. But what is interest coverage ratio in practical terms, and why do analysts and investors scrutinise it so closely?

ICR’s full form is Interest Coverage Ratio. The ICR measures how comfortably a company can pay the interest expenses on its outstanding debts/loans, using the earnings it generates from its core operations. This ratio sheds light on the company’s solvency and debt-servicing capacity.

How Is Interest Coverage Ratio calculated?

The interest coverage ratio formula is both simple and revealing:

Interest Coverage Ratio (ICR) = Earnings Before Interest & Taxes (EBIT)Interest Expense

where,

• EBIT (Earnings Before Interest and Taxes): Operating profit earned by a company, before accounting for interest payments and income taxes.
• Interest Expense: Total interest payable on borrowings for the period.

Example calculation

Suppose ABC Limited posted an EBIT of ₹100 crores with interest expenses amounting to ₹16 crores during a specific financial year. The ICR ratio would be:

Interest Coverage Ratio (ICR) = ₹100 crores₹16 crores = 6.25

This tells us that ABC Limited generates ₹6.25 in profits for every ₹1 of interest it owes — a healthy buffer indicating strong solvency.

Note: Some analysts may use variations such as EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortisation) in the numerator for specific sector analyses.

Why Interest Coverage Ratio matters for businesses

• Solvency signal: The ICR ratio is an indicator of a company’s ability to repay its financial obligations in a timely manner. A higher interest coverage ratio means more profits are available to cover interest expenses, reducing the risk of default and bankruptcy.
• Lending decisions: Bankers and bondholders use ICR as a credit assessment tool to decide whether to extend or renew loans to the company.
• Investor confidence: Investors look for companies with a comfortable ICR buffer, viewing them as less risky and better equipped to survive economic downturns.
• Debt management: Corporate managers rely on the ICR ratio to evaluate capital structure strategies. It helps them decide on whether they should take on more debt or reduce debt obligations.

Interpreting the ratio: What is a good benchmark?

What constitutes a healthy ICR?

While industry benchmarks vary, typical guidance includes:

• ICR > 3.0: Considered very healthy, indicating more than sufficient buffer for debt servicing. Many lenders prefer this minimum.
• ICR between 2.0 and 3.0: Usually acceptable for stable companies but could warrant closer monitoring if sector volatility increases.
• ICR < 1.5–2.0: Warns of potential liquidity issues, as the company may struggle to cover interest costs from operating profits alone.
• ICR < 1.0: Considered distress territory — meaning the company does not earn enough to repay even its interest, let alone the principal amount.

It is important to always compare interest coverage ratios (ICR) with the relevant industry averages and take market conditions into consideration to make sound judgement of the company.

Insights into variability

Some capital-intensive industries (like infrastructure or telecom) may operate with lower ICRs given their stable, regulated revenues. Conversely, cyclical or high-growth sectors are expected to maintain a higher ratio as a buffer against downturns.

Limitations of Interest Coverage Ratio

While interest coverage ratio is valuable for initial screening, it is not a standalone measure of financial health. Here are its key limitations:

• Ignores principal repayment: The formula focuses on interest expense but does not account for principal repayments, which may be sizeable and could put a strain on the cash flows of the company.
• Accounting earnings bias: Figures like EBIT may be subject to non-cash adjustments or accounting choices. Aggressive revenue recognition or expense deferrals can artificially inflate the ratio.
• One-time or seasonal effects: Extraordinary events or seasonality can skew EBIT and, thus, the ICR for a given period. Analysing multi-year trends must be observed to offset this distortion.
• Not a substitute for cash flow analysis: ICR ratio fails to capture how much real cash a business actually generates — especially important for companies with cyclical operating results.
• Does not address all debt obligations: Off-balance sheet liabilities or contingent debts may be overlooked.
• Sectoral and geographical variation: Ratio benchmarks are significantly different across sectors and  market conditions.

Using ICR for Smarter Financial Analysis

The interest coverage ratio — or ICR ratio — is an essential gauge of the company’s ability to meet its debt obligations and is a vital tool for investors, lenders, and corporate managers. However, the ICR should be reviewed alongside other ratios such as the debt-to-equity ratio, current ratio, and operating cash flow.