Interest Coverage Ratio (ICR) Definition
The interest coverage ratio is the financial ratio which is used to measure the ability of the company to pay the interest on debt in a timely manner. Through this investors check the profitability and risk of the company.
Investors concern with its investment in the company that how much interest or return investors can take from his investment. Interest coverage ratio depends on the depreciation and the profit of the company.
An inventor by using this ratio examine that the company can pay the bills in time without sacrificing the operation of the company.
Creditor uses this ratio to find out whether the company can afford the additional debt or not. The company which is not able to pay interest on the debt then it is most difficult for that company to pay to return the principal amount.
For the calculation of the risk involving in the lending, we use the following formula
Interest Coverage Ratio can be calculated by dividing the EBIT by interest expense.
Interest Coverage Ratio = EBIT/Interest expense
Instead of net income, there is EBIT use in this equation. EBIT is also the net income in which the tax expenses and interest add back.
The reason for the addition of EBIT in the above formula instead of net income is that it gives the accurate representation that how the company affords to pay in interest.
Jamaica has the clothing store and she wants to expand his business. But for the expansion of her business, she does not have enough funds.
Then she goes to the bank with her financial statement for the loan. Jamaica EBIT is 50,000 dollars, her interest is 15,000 dollars and her taxes are $5,000. Bank calculate the interest coverage ratio of Jamaica as
Interest Coverage Ratio = EBIT/ Interest expense
Interest Coverage Ratio = $50,000/$15000
From the above result, it is clear that Jamaica has 3.33 time greater earning then her current interest payment.
So she can pay the interest with the principal amount. Jamaica’s company is less risky and she easily pays interest.
Interest coverage ratio may be used to find the health of the company. Investors and analysts use this ratio to find the ability of the company to pay interest on its debt.
If the result of the interest coverage ratio is less then 1 it means that the company is not able to pay the interest and it is the risky company for bank-financing.
If the interest to coverage ratio is equal to 1 then the company is able to pay the interest on its current debt but it is not a much better situation of the company.
Because the company can not pay its principal payment on the debt. So it is a risky company also for bank-financing.
If the ratio is greater then 1 then it is a good sign for the company because the company make more money from which company can pay interest on debt and can save the extra money for principal payment.
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