What Does Interest Coverage Ratio (ICR) Mean?
Interest coverage ratio (ICR) is ratio of a companies total interest expense to its earning before interest and taxes (EBIT).
The formula for calculating interest coverage ratio is as follows:
ICR = EBIT / Cumulative Interest Expenses
In general, a lower interest coverage ratio means a greater debt burden for the company with less earnings to cover the interest expenses.
Divestopedia Explains Interest Coverage Ratio (ICR)
Interest coverage ratio has a different meaning to different stakeholders. From an investor's perspective, an interest coverage ratio of less than 1 indicates that the company is having financial difficulties in meeting its interest obligations. In fact, it is a rule of thumb to stay away from investing in companies that have an interest coverage ratio of less than 1.5 as the chances for default are high. In this sense, the ratio offers a snapshot of the financial health of a business in the short-term.
From a bond holder's perspective, the interest coverage ratio is a safety valve as it gives them an idea of how much a company can pay on its debt obligations before it begins to default. Based on this coverage, some creditors even decide on the interest rates that should be charged. For individual and institutional bond holders, it is a good idea to evaluate their investments at least once a year using the ICR as it will help to better assess the health of their investments.
For business managers, this ratio gives them an idea about the current financial obligations of the company, which can be used to make necessary arrangements in order to ensure these obligations are met. They should understand its implications for the company as a whole and should strive to keep the interest coverage ratio as high as possible.
Despite all of the above precautions, there are some situations where the interest coverage ratio can fall rapidly. This situation can occur when interest rates climb quickly and the company has high levels of low-cost fixed-rate debt coming up for refinance. Or when a company's earning fall due to declining economic conditions or other operational issues.