Interest Coverage Ratio | Meaning, Formula, Calculation and Examples
Last Updated : 21 Apr, 2025
What is Interest Coverage Ratio ?
The Interest Coverage rate( ICR) is a fiscal rate that measures a company's capability to pay interest charges on its outstanding debts. It is a key indicator of a company's financial health and its ability to generate profits to cover its interest payments. The ratio tells us how many times the company's earnings (before interest and taxes) can cover its interest payments.
If a company has an Interest Coverage Ratio of 5, it means that the company can cover its interest payments five times over with its earnings. This is generally considered a good indication of a company's financial health because it suggests that the company has a significant margin of safety and can comfortably make its interest payments.
On the other hand, if a company has a low Interest Coverage Ratio, it means that the company is not generating enough earnings to cover its interest payments. This can lead to financial distress, as the company may struggle to meet its debt obligations and may be at risk of default.
The formula for calculating the Interest Coverage Ratio is:
Interest~Coverage~Ratio=\frac{Earning~Before~Interest~and~Taxes(EBIT)}{Interest~Expenses}
Where:
EBIT = Total Revenue – Cost of Goods Sold – Operating Expenses
Interest Expense = Interest paid on debt during the period
Explanation
The formula for Interest Coverage Ratio is quite simple. The numerator of the formula is the EBIT, which is calculated by subtracting a company's operating expenses from its revenues. EBIT represents the amount of money a company earns before it pays interest and taxes. The denominator of the formula is the company's interest expenses, which are the costs of servicing its debt.
By dividing EBIT by interest expenses, the Interest Coverage Ratio shows how many times the company's earnings can cover its interest payments. For example, if a company's EBIT is ₹1 million and its interest expenses are ₹2,50,000, the Interest Coverage Ratio would be 4. This means that the company's earnings can cover its interest payments four times over.
Significance of Interest Coverage Ratio
The ICR measures a company's ability to pay interest on its debt obligations. A higher ratio indicates that a company is more capable of meeting its interest obligations, while a lower ratio indicates that it may be at risk of defaulting on its debt. In addition to providing insight into a company's ability to meet its debt obligations, the Interest Coverage Ratio is also useful for comparing companies within the same industry. For example, if two companies have similar debt levels but one has a higher Interest Coverage Ratio, it may be a better investment because it is generating more earnings to cover its interest payments.
Overall, the Interest Coverage Ratio is an important financial metric that provides insight into a company's financial health and its ability to generate profits to cover its interest payments. It is a useful tool for investors and creditors who want to assess a company's risk profile and potential for growth.
Illustration 1:
From the following information, calculate the Interest Coverage Ratio (ICR) :
Particulars | ₹ |
|---|
| 10,000 Equity Shares of ₹10 Each | 1,00,000 |
| 10% Debentures | 50,000 |
| Long-term Loan from Banks | 50,000 |
| Interest on Long-Term loans from Banks | 5,000 |
| Profit after Tax | 75,000 |
| Tax | 9,000 |
Solution:
Interest on 10% Debentures = 50000\times\frac{10}{100}=₹5000
Profit Before Interest and Tax = Profit After Tax + Tax + Interest on Debentures + Interest on Long-Term Loans from Banks
= 75000 + 9000 + 5000 + 5000 = ₹94,000
Total Interest Amount = Interest on Debentures + Interest on Long-Term Loans from Banks
= 5000 + 5000 = ₹10,000
Interest~Coverage~Ratio=\frac{Earning~Before~Interest~and~Taxes(EBIT)}{Interest~Expenses}
=\frac{94,000}{10,000}=9.4~Times
Therefore, the interest coverage ratio (ICR) of the company is 9.4 times, which indicates that the company's earnings are sufficient to cover their interest expenses 9.4 times over.
Illustration 2:
Suppose a company has a profit after tax (PAT) of ₹1,00,000, and it has a long-term debt of ₹5,00,000 with an interest rate of 12%. The company's tax rate is 30%. Calculate the interest coverage ratio (ICR) of the company.
Solution :
To calculate ICR, we need to first calculate the earnings before interest and taxes (EBIT). We can calculate EBIT by subtracting the total interest expenses from the PAT:
EBIT = PAT + Total Interest Expenses
Total Interest Expenses = Long-term Debt x Interest Rate
Total Interest Expenses = ₹5,00,000\times\frac{12}{100}
Total Interest Expenses = ₹60,000
Profit Before Tax = Profit~After~Tax\times\frac{100}{100-Tax~Rate}
Profit Before Tax = ₹1,00,000\times\frac{100}{100-30}
Profit Before Tax = ₹1,43,000
EBIT = Profit Before Tax + Total Interest Expenses
EBIT = ₹1,43,000 + ₹60,000
EBIT = ₹2,03,000
Now, we can calculate the interest coverage ratio by dividing the EBIT by the total interest expenses:
Interest~Coverage~Ratio=\frac{Earning~Before~Interest~and~Taxes(EBIT)}{Interest~Expenses}
=\frac{2,03,000}{60,000}=3.38~Times
Therefore, the interest coverage ratio (ICR) of the company is 3.38 times, which indicates that the company's earnings are sufficient to cover their interest expenses 3.38 times over.
Similar Reads
Types of Accounting Ratios with Formula Accounting ratios are a set of financial metrics used to analyze different components of accounting information in order to derive proper conclusions to be further used by different users of such information for making informed decisions. They form an important part of the analysis and interpretatio
8 min read
Liquidity Ratio: Meaning, Types, Formula and Illustrations What is Liquidity Ratio?Liquidity ratios are the ones that determine the organisation’s ability to meet its short-term obligations by defining a systematic relationship between the amount of current/liquid assets and that of its current/short-term obligations.Liquidity ratios assist analysts and inv
5 min read
Current Ratio: Meaning, Significance and Examples The ratio that is used to derive a relation between the current assets and current liabilities of a firm is called a Current Ratio. It is used to determine whether the current assets of a firm would be sufficient to pay off its current obligations or not. In other words, it is used to depict the mag
4 min read
Liquid/Quick Ratio: Meaning, Formula, Significance and Examples Liquid ratio is the one that is used to derive a relation between the liquid assets and current liabilities of a firm. It is used to determine whether the liquid assets lying with a firm would be sufficient to pay off its current obligations or not. In other words, it is used to depict the magnitude
4 min read
Debt-Equity Ratio: Meaning, Formula, Significance and Examples The Debt-Equity ratio is a financial metric, which establishes a relationship between the total debt owed by the firm to outsiders and the funds employed by the shareholders. This ratio is used to determine the proportion of debt availed from outsiders and the funds raised by way of equity. The term
4 min read
Total Assets to Debt Ratio: Meaning, Formula and Examples What is Total Assets to Debt Ratio?Total Assets to Debt Ratio is the ratio, through which the total assets of a company are expressed in relation to its long-term debts. It is a variation of the debt-equity ratio and gives the same indication as the debt-equity ratio.Total Assets: Total Assets consi
3 min read
Proprietary Ratio: Meaning, Formula, Significance and Examples Proprietary ratio is the one that is used to express a relationship between the amount invested by proprietors in the business and the total assets owned by the business. In other words, the proprietary ratio measures the extent of assets funded by the proprietor's funds. It denotes the percentage o
3 min read
Interest Coverage Ratio | Meaning, Formula, Calculation and Examples What is Interest Coverage Ratio ?The Interest Coverage rate( ICR) is a fiscal rate that measures a company's capability to pay interest charges on its outstanding debts. It is a key indicator of a company's financial health and its ability to generate profits to cover its interest payments. The rati
4 min read
Activity Ratio: Meaning, Formula and Significance What is Activity Ratio?Activity ratios, also known as turnover ratios, are essential metrics in the field of accountancy. These ratios enable the evaluation of a company's operational efficiency and effectiveness. By analyzing various activity ratios, such as the Inventory/Stock Turnover Ratio, Trad
4 min read
Trade Receivables Turnover Ratio: Meaning, Formula, Significance and Illustration A financial indicator called the trade receivables turnover ratio is used to assess how successfully a business collects payment from its clients for credit sales.The effectiveness of a company's credit and collection practices is calculated by the trade receivables turnover ratio. It is figured up
3 min read