Interest Coverage Ratio: What is it?

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Definition

The interest coverage ratio (ICR) is a financial metric used to assess a company’s ability to meet its interest payments on outstanding debt.

What is interest coverage ratio?

The ratio measures the extent to which a company’s operating income can cover its interest expenses. A higher ICR indicates a stronger ability to fulfil interest obligations, which is an important consideration for creditors and investors.

The interest coverage ratio is calculated using the following formula:

Interest coverage ratio = operating income / interest expenses

A ratio of 1 or lower suggests that a company’s operating income is just enough to cover its interest expenses. This is often seen as a red flag, as it indicates a lower margin of safety for debt servicing. On the other hand, a ratio greater than 1 indicates that a company generates more operating income than is required to cover its interest expenses, which is generally viewed as a positive sign. Be aware that a significantly high ICR can indicate that a company may not be efficiently using its debt to generate returns, as it has an excess capacity to cover interest costs.

For investors, the ICR is an important indicator of a company’s financial stability. A healthy ICR suggests that the company has the capacity to meet its financial obligations, which can enhance investor confidence.

While the ICR provides valuable information about a company’s debt-servicing capacity, it does not provide a complete picture of its overall financial health. It does not account for other obligations like principal repayments, or consider future investments and capital expenditures.