Before taking on additional debt, internal decision-makers and lenders probably want to know that the company can take care of its existing obligations.
While there are many financial metrics to evaluate this, the interest coverage ratio (ICR) is one commonly used figure.
In this guide, we’ll provide an overview of the interest coverage ratio, how to calculate it, and what the ICR indicates to potential investors and creditors about a company.
What is interest coverage ratio?
The interest coverage ratio (ICR) is a financial metric that reflects a company’s ability to cover the interest payments on its outstanding debt or notes payable. The ICR may also be referred to as the times interest earned (TIE) ratio.
It’s found by taking the company’s earnings before interest and taxes, or EBIT, and dividing it by the interest expense for the same time period. It helps teams determine if the company generates enough earnings to cover interest expenses.
This ratio is typically utilized not by internal decision-makers but by external stakeholders like creditors and investors who are deciding how easily a company can handle its current debt and how that might affect future borrowing.
How to calculate the interest coverage ratio
Interest coverage ratio formula
The formula to calculate the interest cover ratio is as follows:
While a relatively straightforward formula, there are a few additional calculations required if the EBIT value is not already known.
Here, the EBIT is also referred to as operating income, which has the following formula:
Of note, the portion of the formula that subtracts the cost of goods sold (COGS) from revenue determines the gross profit. Thus, operating income is found after subtracting selling, general, and administrative (SG&A) costs, as well as depreciation and amortization from this value.
The interest expense for the previous period is likely reported as a line item on the income statement, which should be easy to locate and use in the ICR formula.
Step-by-step calculation for interest coverage ratio
The interest coverage ratio formula involves a series of simple calculations using figures from the profit and loss statement. To better understand the various components that go into this metric, here is a breakdown of the individual steps in the ICR calculation.
Step 1: Find the gross profit
First, find the gross profit by subtracting the cost of goods sold from the total revenue:
Step 2: Find the earnings before interest and taxes (EBIT)
Next, subtract the SG&A expenses and depreciation and amortization from the gross profit to find the EBIT:
Again, this value may also be referred to as the operating income.
Step 3: Identify the interest expense
After finding the EBIT, locate the interest expense line item from the income statement.
If a recent figure isn’t available, calculate the interest expense with the following formula:
Here, the principal is the outstanding balance of the debt, the rate is the annual interest rate applied to the debt, and time is the duration in question, like one year.
Step 4: Calculate the interest coverage ratio
With the EBIT and interest expense figures, use the provided formula to calculate this ratio:
Common pitfalls in interest coverage ratio calculation
The calculation of the interest coverage ratio isn’t too complicated. That said, there are a lot of moving parts and different figures involved in the formula, which can lead to accidental errors and inaccuracies.
One of the most common pitfalls is using the wrong earnings figure. Most commonly, EBIT is used in the calculation. However, specific lenders or teams may use the EBITDA value instead, which can lead to some variation in the final figure.
Additionally, some discrepancies may occur if the interest expense value is not already provided and must be determined. Any variations in this figure from what the lender actually charges can provide a misleading ICR value.
Interest coverage ratio vs. fixed charge coverage ratio (FCCR)
ICR is commonly associated with the fixed charge coverage ratio, or FCCR. However, the FCCR takes a wider look at the company’s ability to cover all fixed costs, not just interest.
The FCCR formula considers additional fixed costs, like debt and lease repayments:
Interest coverage ratio vs. debt service coverage ratio (DSCR)
Similarly, the ICR and debt coverage service ratio (DCSR) are often used in tandem for ratio analysis before a company takes out additional debt.
While the ICR exclusively focuses on interest expenses, the DCSR is concerned with how easily the company can make all payments for outstanding debt, including principal repayments.
The debt coverage ratio formula looks like this:
Interpreting the interest coverage ratio
What is a good interest coverage ratio?
Is it better to have a higher or lower interest coverage ratio?
The general rule of thumb is that an ICR at or above two is ideal. This means the company can cover interest payments with earnings at least twice during the period, indicating some financial resiliency in the event of a market downturn or other roadblock.
A higher ICR shows potential lenders and investors that the company can comfortably cover interest payments with earnings without having to dip into cash reserves.
Industry benchmarks and variations
Like many other financial metrics, it’s important to note that what’s considered a “good” ICR can vary between industries. For example, it’s generally not helpful to compare the ICR of a retail business against that of a software company.
Certain industries are more capital intensive and may carry larger debt burdens than others, leading to a lower ICR. Variations in typical earnings and margins across different sectors also play an important role.
Limitations of interest coverage ratio
The interest coverage ratio provides important insights related to the company’s use of earnings to cover interest expenses.
However, it only provides a single snapshot of the company’s ability to pay interest based on historical data. It doesn’t consider future fluctuations that may impact this ability, such as a drop in sales revenue, a spike in COGS, or changes in interest rates.
Put simply, assessing the ICR is not a surefire way to determine if a company is financially stable or in peril. It’s best to use alongside other ratios to gain a more comprehensive view of a company’s financial position.
Interest coverage ratio example
Take a local bakery, Becky’s Breads, which reported the following figures for 2024:
- Revenue: $210,000
- Cost of goods sold (COGS): $95,000
- Wages and salaries: $70,000
- Maintenance costs: $3,600
- Administrative expenses: $24,000
- Depreciation and amortization: $4,000
- Interest expense: $5,500
The owner is considering taking out a loan to renovate the bakery’s customer seating area. However, the lenders will want to review the business’s interest coverage ratio first to determine how risky this loan would be given the business’s outstanding debt.
Using the ICR formula, we can first find the operating income with the following steps:
EBIT = $210,000 – $95,000 – $70,000 – $3,600 – $24,000 – $4,000
= $13,400
Then, we divide this value by the interest expense to find the ICR:
Interest coverage ratio = $13,400 / $5,500
= 2.44
In this scenario, the bakery could cover its interest expense with earnings alone almost two and a half times during the year. This signals that the business isn’t burdened by its current obligations and even has capital left over to dedicate to value-add activities.
Factors affecting the interest coverage ratio
Based on the number of inputs for the ICR formula, there are several variables that influence this ratio. Here’s a closer look at some of the main factors that can affect this metric.
Impact of earnings variability on the ratio
The ratio is directly related to the company’s earnings for a given period. There are several measures of a company’s earnings; however, this formula is concerned with earnings before interest and taxes (EBIT).
Thus, the company’s tax obligations for the year won’t impact the ICR. However, other critical line items from the income statement, like revenue, COGS, employee wages, and depreciation, all have a direct effect on the ratio.
Any fluctuations in these figures can impact the earnings a company generates and thus its ability to cover interest expense during the period.
Role of fixed versus variable interest rates
The other side of the ICR equation is the interest expense. If earnings are equal, a higher interest expense will lead to a lower ICR, and vice versa.
Here, it matters whether the debt has a fixed or variable interest rate. A fixed rate is easier to track over time and provides better predictability. However, dealing with a variable interest rate can create some uncertainty and variations in the ICR value, even if earnings remain relatively stable.
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