A company’s ability to pay its interest obligations on outstanding debt is measured by the interest coverage ratio. A lower ICR is an indicator of a weak financial position and risk of bankruptcy. A lower ratio reflects that lower operating profits are available to meet the interest obligations of the firm. This increases the firmâ€™s risk as if the interest rate increases, the entity will default in the interest payments. A higher interest coverage ratio is an indicator of the strong financial position of an entity. It reflects that the entity has sufficient profits for meeting the interest obligations and can bear the changes in interest rates. A significantly higher ratio also indicates that entity is not utilizing the opportunities of using leverage. A rule of thumb says, an ICR of greater than two is termed as acceptable to the investors but it may vary as per the industry. If the ICR is less than 1, it might reflect a poor financial condition and indicate that the firm will not be able to meet its current interest obligations.
Uses and Limitations
The interest coverage ratio helps assess an entityâ€™s ability to pay off its current interest obligations. It helps the lenders, creditors, and debt providers of a firm assess the riskiness of investing in the firm. By studying and analyzing the ICR of five years, the stability of an entity can be assessed regarding the payment of interest.
There are certain problems in using interest coverage ratio, which must be studied for analyzing the applicability of interest coverage ratio. First, this ratio is calculated on the earnings before taxes which implies; the earnings are overstated in the calculation of ICR because a portion of profits will be paid towards taxes. Second, the use of EBIT does not represent actual cash flows as accrued revenues are also included in the calculation of EBIT. Therefore, an entity can easily manipulate the EBIT as it is an accounting figure and not the actual cash flows. Also, the comparison of interest coverage ratios of companies in different industries and businesses will not give a fruitful result. This is because there will be high variation in the calculation of revenues and expenses, and the risk profile would vary as per the nature of business. So, an investor must compare the firms within an industry and having the same business with a similar risk profile.
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