Understand the meaning of Interest Coverage Ratio

Interest Coverage Ratio is the mathematical way of analyzing the company’s financial health with their paying capacities and abilities. The motive of calculating this ratio is only to determine how much a company has deep in water that they can pay interest with expenses on its outstanding debts. This ratio method is used for counting all debts and interests that have been levied on it. It is measured with all debts or we can say that divides earning before interest and taxes by interest expenses. The end result is taken out for evaluating the company’s financial position that depends on ratio points such as (less than 1, and 1.5), and (more than 1.5 and 2).

The interest coverage ratio is analyzed for knowing the company’s accuracy to pay interest expenses on its debts regularly but the matter is, how the company allows the analysts to evaluate this ratio, the company has to allow them due to the right of investors to place the right investment and this is also the most advantageous and easy method to measure company’s current paying abilities with their earnings. If a company earns well in a month, it can survive in the world of debt or be able to pay interest expenses on debts without selling any inventories but with this ratio company and analysts can evaluate how much they can meet financial obligations on its debts.

Who used the Interest Coverage Ratio (ICR)?

Interest Coverage Ratio is used by the analysts. Analysts can be of two types:

  • Outer analysts
  • Internal analysts

Outer analysts are the analysts that perform outside the company by using EBIT to measure the company’s financial stage by comparing with all similar industries that are located in the same area. These outer analysts are investors such as other companies, banks or other financial institutions, lenders and creditors, and other money providers companies. Auditors can also be the reputed analysts at the time of auditing.

The purpose of acquiring this method is to focus on a company’s strength and it is necessary to be familiar with a company’s paying abilities before investing and offering funds so that they can know that they will be assessed any profit as a dividend in the future as a shareholder or interest on debts as a financial lender. 

Internal analysts are the analysts that perform inside the company by using EBIT to measure their companies’ earning capacity and revenue with operating profits so that they can run their business in accordance with ratio results. These analysts are companies’ management, team, accountants who perform inside the company based on regular profits and earnings with interest payments on outstanding debts.

The purpose of both analysts is the same to identify the company’s health for whether they can cover all interest expenses on time or not. 

If they find that the company is going into a draw, they refuse to invest but if they find that the company is going in a good way or ignore fluctuations so they decide to invest regularly.

These analysts utilize EBITDA and EBIAT instead of EBIT in some cases, it is known as variations which are used to calculate interest with times interest earned (how much times a company can pay interest without meeting any fluctuations. These variations are the most effective ways to get a clear image of a company’s health and wealth as well as goodwill. EBITDA is the first variation that is used instead of EBIT in which depreciation and amortization are not involved while calculating but they made a higher interest coverage ratio so that company is liable to pay interest expenses and we know what a higher interest ratio shows.

On the other hand, EBIAT is another variation that is used to calculate interest in which taxes are deducted because it is a very important element of the company’s liabilities, not the debts. Taxes are the only one who tells the actual conditions of the business such as if the company is not paying taxes regularly, it means they go into bankruptcy. All three variations are good to use but methods are different with the accordance of deduction parts.

Ideal Ratio of ICR

The ideal ratio of ICR should be 2 but sometimes it can be 1.5, it is ok but not countable good. To make a good ICR, it is necessary to have good financial health in all ways that depend on the company’s paying interest expenses. Interest Coverage Ratio has been made only to determine the paid interest expenses. 

The reason for the low interest ratio is fluctuations occurring in the business due to recession, bankruptcy, financial accidents, and many more reasons.

The reason for the high interest ratio is high goodwill, high revenue, and operating profits that a company needs to have in a company to meet all debts with interest.

When does ICR show negative?

ICR shows negative when analysts get out the ICR Ratio is less than 1.5 or 1. It shows the decline of the company’s revenue and cash flows. It does not put a good impact on the company’s health, it could be a dangerous stage in which the company lies without any financial support.

When does ICR show positive?

ICR shows positive when analysts get out the positive result or ICR ratio is more than 1.5 or 2. It shows the inclination of the company’s revenue and cash flows as well as operating profits. 

How to calculate ICR with a formula?

ICR is calculated by dividing earnings before interest and tax by interest expenses during a given period.

EBIT = Earnings before interest and tax / Interest Expenses

OR, 

EBITDA = Earnings before interest, taxes, depreciation, and amortization / Interest Expenses

Or,

EBIAT = Earnings before interest, amortization, and taxes / Interest Expenses

Benefits of using Interest Coverage Ratio

If analysts use this formula to measure a company’s profit and revenue so that they can know the company is liable to pay interest expenses on outstanding debts within a given period. This ratio is applied for short-term debt as well as long-term debt. Creditors, lenders, and investors play an important role in identifying the risk in the business and familiarity with the company’s paying capacity. 

It is beneficial when the investors are thinking about investment and creditors are thinking of providing funds to the company to meet big projects, they have the responsibility to determine the company’s current situation by analyzing all debts. With this ratio, analysts can get a clear picture of financial charts for checking financial stability.

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