Interest Coverage Ratio 

The Interest Coverage Ratio (ICR) is a crucial financial metric used in the stock market and investment industry to assess a company’s ability to meet its interest obligations. It is beneficial for investors, creditors, and analysts to determine a company’s financial stability. This guide explains the concept of ICR, its formula, types, real-world examples, and its significance in economic analysis. 

What is the Interest Coverage Ratio?

The Interest Coverage Ratio (ICR) measures how easily a company can cover its interest expenses using earnings before interest and taxes (EBIT). It is an essential indicator of a company’s financial health and debt management ability. 

• A higher ICR → Indicates strong financial health and a lower risk of default. 

• A lower ICR → Suggests possible liquidity issues and financial distress. 

Companies with a higher ICR are generally more attractive to investors and lenders because they are less likely to fail to meet their interest obligations. 

Understanding Interest Coverage Ratio 

The Interest Coverage Ratio (ICR) measures a company’s ability to pay interest on its outstanding debt using its operating earnings. It helps determine financial stability by comparing earnings before interest and taxes (EBIT) to interest expenses. A higher ratio suggests more vigorous financial health, while a lower ratio indicates potential difficulty in meeting debt obligations. 

This ratio benefits investors and lenders by providing insights into a company’s risk level. Industry norms and business models influence acceptable ICR levels, making comparing companies within the same sector essential for accurate analysis. 

Formula and Calculation of Interest Coverage Ratio 

The formula to calculate ICR is: 

ICR= EBIT/Interest Expense 

Where: 

• EBIT (Earnings Before Interest and Taxes) = Operating income before deducting interest and taxes. 

• Interest Expense = Total interest paid on the company’s outstanding debt. 

Example 1: Basic Calculation 

Company A Financials: 

• EBIT = US$8,580,000 

• Interest Expense = US$3,000,000 

ICR= 8,580,000/3,000,000=2.86  

Interpretation: 

Company A can pay its interest expenses 2.86 times using its earnings before interest and taxes. This suggests the company has a moderate ability to meet its interest obligations. 

Types of Interest Coverage Ratios 

The Interest Coverage Ratio has several variations, depending on the financial perspective required. 

1. EBIT Interest Coverage Ratio

Purpose: 

This is the most widely used version of the Interest Coverage Ratio. It calculates how often a company’s earnings before interest and taxes (EBIT) can cover its interest expenses. 

How It Works: 

• EBIT represents the company’s operating income before subtracting interest and taxes. 

• This version gives a balanced view of a company’s ability to meet its debt obligations. 

• Since EBIT includes all operating revenues and expenses, it is not affected by tax payments or non-cash expenses like depreciation and amortisation. 

Best Use Cases: 

• Commonly used in financial reports and credit analysis. 

• Suitable for companies across all industries, as it clearly measures debt repayment capacity. 

• Helpful for comparing companies in the same industry to assess their financial stability. 

2. EBITDA Interest Coverage Ratio

Purpose: 

This ratio is similar to the EBIT Interest Coverage Ratio but adds non-cash expenses such as depreciation and amortisation. It provides a broader perspective on a company’s ability to pay interest expenses. 

How It Works: 

• EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) represents a company’s operating income before deducting both interest and non-cash expenses. 

• Since depreciation and amortisation are accounting adjustments, they do not directly affect cash flow. 

• By including these figures, this ratio offers a more realistic view of available cash flow for paying interest expenses. 

Best Use Cases: 

• Useful for industries with high non-cash expenses, such as manufacturing, infrastructure, and real estate. 

• Helps investors evaluate companies with significant depreciation costs due to large fixed assets. 

• Preferred by analysts when comparing companies with different levels of capital investment. 

3. EBITDA Less Capex Interest Coverage Ratio

Purpose: 

This ratio takes the EBITDA Interest Coverage Ratio and further adjusts it by subtracting capital expenditures (Capex). It provides an even more accurate reflection of a company’s cash availability to cover interest expenses. 

How It Works: 

• Capital expenditures (Capex) are funds spent on acquiring or upgrading physical assets such as property, plants, and equipment. 

• Companies with high Capex (such as telecom, energy, and real estate firms) might appear profitable based on EBITDA but still have limited free cash flow. 

• This ratio helps determine how much cash is available after accounting for necessary investments in physical assets. 

Best Use Cases: 

• Especially important for businesses with extensive infrastructure or equipment investments. 

• Used by analysts to evaluate cash flow sustainability in capital-intensive industries. 

• Helps lenders assess whether a company can pay interest while maintaining long-term asset investments. 

Each type of ICR provides a different viewpoint based on the company’s financial structure and operational expenses. 

Examples of Interest Coverage Ratio 

Let’s look at some real-world examples of well-known companies to better understand the Interest Coverage Ratio. 

Example: Walmart (US Market) 

Walmart’s Financials (Latest Reported Year): 

• Operating Income (EBIT) = US$20.428 billion 

• Interest Expense = US$1.787 billion 

ICR= 20.428/1.787=11.44 

Interpretation: 

Walmart can cover its interest payments 11.44 times, indicating strong financial stability and a very low risk of default. This makes Walmart an attractive option for investors looking for financially secure companies. 

Example: Singapore Exchange (SGX: S68) 

SGX Financials (Quarter Ending June 2024): 

• Operating Income (EBIT) = SGX 311 million 

• Interest Expense = SGX 7 million 

ICR= 311/7=44.43 

Interpretation: 

Singapore Exchange (SGX) has an exceptionally high ICR of 45.36, meaning it generates sufficient operating income to cover its interest expenses multiple times over. This reflects a very low risk of financial distress, making SGX a stable entity in the financial market. 

Frequently Asked Questions