What is the Interest Coverage Ratio? Meaning, Types, and Formula

The interest coverage ratio assesses a company's financial stability by measuring how easily it can use its earnings to pay interest on its debts. Business owners make their borrowing decisions using this ratio. A higher ratio indicates minimal risk for a company to take loans while ensuring financial security.

A company with a decent income has enough funds to handle temporary halts in revenue. The buffer ensures the company can still pay its debts during low-business periods. Read on to understand the meaning of interest coverage ratio, its formula and its types.

What is the Interest Coverage Ratio?

The financial metric of interest coverage ratio (ICR) assesses a company's ability to pay interest on its outstanding debt. You may calculate it by dividing the company’s EBIT (Earnings Before Interest and Taxes) by its interest obligations. The result indicates the number of times a company can cover its interest expenses from its earnings.

Read Also: Interest Rate: Definition, How It Works, Examples

Types of Interest Coverage Ratio

While a company can have only one ICR, it may differ based on its calculation method. Here are the major variations:

1. EBIT Interest Coverage Ratio: EBIT ICR measures how many times a company can use its Earnings Before Interest and Taxes to pay its due interest expenses.
2. EBITDA Interest Coverage Ratio: EBITDA ICR measures how many times a company can use its Earnings Before Interest, Tax, Depreciation and Amortisation to pay its due interest expenses.
3. EBITDA Less CapEx: This ratio checks the number of times a company can use its EBITDA to pay interest expenses after deducting capital expenditures (CapEx).
4. Fixed Charge Coverage Ratio (FCCR): The FCCR assesses a company’s ability to cover its short-term financial obligations.

Interest Coverage Ratio Formula

The interest coverage ratio calculation involves dividing a company’s operational income by its interest obligations. Here is the interest coverage ratio formula:

ICR = EBIT/Interest Expense

Here,

EBIT = Earnings Before Interest and Taxes

Interest Expense = Total Interest Obligations

How to Calculate Interest Coverage Ratio (ICR)?

The interest coverage ratio calculation method involves dividing the company’s EBIT by its debt interest expenses. Based on the formula, if a company’s EBIT is Rs 100 Crore and its interest expenses are Rs 16 Crore, its interest coverage ratio will be 6.25. This interest coverage ratio means the company has enough earnings to pay its interest liabilities 6.25 times in a financial year.

Importance of Interest Coverage Ratio

The ICR is a crucial metric in many ways, including the following:

• Crucial for assessing an organisation’s financial risk
• Provides insight into a company’s financial stability
• Allows comparative analysis of companies within an industry
• Indicates a company’s ability to withstand industrial challenges or economic downturns
• Assesses a company’s creditworthiness, helping lenders make better lending decisions
• Helps companies make their financial strategies to maintain a healthy balance between income and debt
• Serves as an early warning sign for upcoming financial distress

Uses of Interest Coverage Ratio

The interest coverage ratio has numerous benefits and uses. Businesses, analysts, and investors use it in the following ways:

• Businesses use it to measure their financial stability, based on which they make borrowing decisions or plan their finances.
• Lenders use the ICR to assess a company’s creditworthiness, as a high ICR indicates minimal chances of loan default.
• Investors use this ratio to evaluate a company’s profitability before investing their money.

Read Also: What is the Debt Service Coverage Ratio (DSCR)?

Limitations of Interest Coverage Ratio

Now that you understand what is interest coverage ratio, its calculation, uses, and importance, knowing its limitations is also important. The following points emphasise ICR’s limitations:

• The ratio does not consider seasonal factors that may distort the interest coverage ratio calculation.
• It does not directly factor in tax expenses' impact on cash flow since it uses EBIT.
• Since the ICRs of different industries may vary, it is not ideal to compare their profitability or performance.
• When applying the interest coverage ratio formula, a company can exclude a certain debt.

Example of Interest Coverage Ratio

Imagine a scenario where a company’s EBIT is Rs 10 Lakh and its interest expense is Rs 2 Lakh.

Here's the calculation using the interest coverage ratio formula:

ICR = EBIT/Interest Expense

= Rs 10,00,000 / Rs 2,00,000

= 5

This ratio indicates that the company's income is five times higher than its interest obligations. Here, the company is in a strong position to conveniently make its interest payments.

How to Analyse Interest Coverage Ratio?

Here’s a quick look into analysing the interest coverage ratio:

• Ratio Under 1: The company is not generating enough funds to cover its interest obligations.
• Ratio 1 to 1.5: The company may struggle to repay its debt interest.
• Ratio 1.5 to 2.5: The company has sufficient earnings to cover its debt costs but should closely monitor for potential risks.
• Ratio Above 2.5: The company earns more than enough to cover its debt costs.

Read Also: Simple Interest Rate - Meaning, Formula, and Example

How to Interpret Interest Coverage Ratios?

The interest coverage ratio indicates a company's ability to manage its debt costs. Here is how to interpret the interest coverage ratio calculation results:

Interest Coverage Ratio vs Debt Service Coverage Ratio

The major difference between the interest coverage ratio and debt service coverage ratio (DSCR) lies in what they measure. Here are a few points of difference between them:

Role of Interest Coverage Ratio in Personal Loan Approval

When you apply for a Personal Loan as a self-employed professional, lenders, including Hero FinCorp, may assess your interest coverage ratio to measure your capacity to repay the debt. Here is how the ICR is crucial in your Personal Loan approval:

• When measuring your creditworthiness, loan providers assess your ability to repay your interest obligations.
• A low ICR indicates a higher risk regarding your ability to repay loan interests, which may affect approval chances.
• Loan agreements often include debt covenants, requiring you to maintain a certain level of ICR.

Read Also: How To Get A Personal Loan With A Co-Applicant

Steps to Apply for a Personal Loan Online

Follow these steps to apply for a Personal Loan with Hero FinCorp online:

Step 1: Visit Hero FinCorp's official website.

Step 2: Click ‘Apply Now’ in the Personal Loan section.

Step 3: Provide your mobile number and authenticate with an OTP.

Step 4: Verify your KYC details to check your eligibility.

Step 5: Double-check the details and click ‘Submit’ to apply for a loan.

Conclusion

Understanding the interest coverage ratio is crucial for maintaining your business’s financial health. A high ICR can help you obtain a Personal or Business Loan easily from Hero FinCorp, as it attracts favourable terms and conditions. Withbusiness growth, monitoring this metric is essential to safeguard your cash flow and make smarter financial decisions. Hero FinCorp is a reputable NBFC offering Personal Loans of up to Rs 5 Lakh with easy eligibility conditions.

Frequently Asked Questions

1. What is a Good Interest Coverage Ratio?

An interest coverage ratio above 1.5 is sufficient to indicate financial stability and attract lenders and investors.

2. How does the Interest Coverage Ratio affect loan eligibility?

Since a high ICR indicates financial stability and your ability to cover interest obligations, it may project you as a creditworthy borrower in the eyes of lenders.

3. Is the Interest Coverage Ratio relevant for Personal Loans?

When applying as a self-employed professional, the ICR is relevant for a Personal Loan.

4. Is the Interest Coverage Ratio useful for start-ups?

A high interest coverage ratio helps start-ups attract investors. They invest in a company only if they foresee growth prospects through its financial stability.

5. What does a high ICR mean?

A high ICR means a company has enough funds to cover its debt interest obligations from its cash reserves.