There are dozens of different ways to measure the success of a company, and how to determine whether or not you should invest in it.
If you're looking to make risk management a crucial element of your portfolio, one measure that may be of good use to you is the interest coverage ratio (ICR). ICR is important for business people and investors alike, and can help you determine how profitable a businesses is, how dependable it is, how its earnings have fluctuated from quarter to quarter and where to go with that knowledge.
So what is the interest coverage ratio, and how do you calculate it?
What Is Interest Coverage Ratio?
The interest coverage ratio for a company is a debt ratio that is designed to give you an idea of how able the company is to pay its interest payments. In doing this, you can get a sense not only of how well the company is doing with regard to earnings, but how much debt it is in or is accruing.
A company's ICR can also be seen as how many times a company could pay its interest expenses with its earnings before interest and taxes (EBIT). So naturally, the higher the ICR is, the more dependable a company can be viewed as when it comes to repaying their debts. A company with an ICR around 8 - meaning it has eight times as much in EBIT as in debt interest - is going to have a much sunnier outlook than a company who's ICR is only 1.
What is a Healthy Interest Coverage Ratio?
If you're an investor, what is a decent ICR for a company you're looking at to have? A company's interest coverage ratio should at least be higher than 1.5; below that and there is legitimate cause for concern that this company may be struggling to repay their debts.
Preferably, a company should have an interest coverage ratio of 3 or higher for you to consider investing in it. Of course, ICR has its limits and shouldn't be the one thing you're looking at. But when using it as one of the various figures you're using to gauge the merit of a company, the higher the better.
How to Calculate Interest Coverage Ratio
The formula for calculating interest coverage ratio looks simple enough at face value. The formula is:
Interest Coverage Ratio = Earnings Before Interest and Taxes/Interest Expense
If you have the EBIT and interest expense in front of you, you're most of the way to figuring out your ICR.
If you don't have those figures immediately available, it's possible you'll need to do a little more math first. EBIT is neither gross profit nor net income, so if you have one of those figures you'll need to either subtract or add to get there. If you have the company's gross profit (the total sales revenue minus the cost of goods sold), you'll still need to subtract operating expenses like salary and rent to get the EBIT. If you have the company's net income (gross profit minus operating expenses, interest expense and taxes), you need to add the taxes and interest expense back in.
In this case it would be a lot of additional figures you would need. Luckily, they are all easily available on a company's income statement.
Example of Interest Coverage Ratio
Say a company's annual EBIT was $9.2 million, and their interest expense was found to be $3.5 million. Let's do some division:
ICR = 9,200,000/3,500,000 = 2.63
An ICR of 2.63 would mean this company can cover their interest expenses more than 2 times with the EBIT.
2.63 would likely be seen as an ICR that, while not disastrous, could certainly use improvement.
In another example, let's say you know that the gross profit of a company is $14.5 million, but that's all you have. You check the income statement to find that its various operating expenses total $3 million, and they have $2 million in interest expenses. You now have enough to calculate ICR:
ICR = (14,500,000 - 3,000,000)/2,000,000 = 11,500,000/2,000,000 = 5.75
Or, if you have the net income, you can return to the income statement for other information. If you know the net income for a company is $4 million, check the income statement and see that the company has $1 million in income taxes and $2.75 million in interest expense, you can now calculate:
ICR = (4,000,000 + 1,000,000 + 2,750,000)/2,750,000 = 7,750,000/2,750,000 = 2.82
Why Use ICR?
No investment can realistically qualify as a "safe investment." But if you're looking for investments that could be safer than other options, interest coverage ratio can be a very helpful tool. After all, as an investor you want to see how healthy and dependable a company is before putting any of your money into it. And a company that is currently able to pay their interest expenses several times over certainly will give you the impression of a stable, healthy business.
ICR can be great for viewing a company's short-term financial success. Doing that several times over may be able to give you a bigger picture. Looking at the ICR of a company's quarterly income statements over a period of time can give you a better picture of whether the company ability to pay those debts is improving or not. If it is, you may have a healthy investment. If it's going the other direction, you may be spotting a red flag.
ICR is useful for business people too. If you find that your ICR is lacking or getting smaller, you can have the appropriate sense of urgency for tackling the issue. If your business has too low of an interest coverage ratio, you may find that potential lenders are also aware of this, and it could easily prohibit you from getting approved for a loan you need if the lender doesn't believe in your ability to fully repay the debt and interest.
Limits to Using ICR
Interest coverage ratio, while helpful, is hardly the definitive tool for determining a company's health. If you look at ICR by itself, you could miss a lot of contextual information. For example, if you're looking at a quarterly ICR, it could be a poor season for that particular industry, and thus not an ideal way to gauge the overall health of the company.
The big limitation to ICR, ultimately, is that EBIT doesn't deduct taxes. It can be helpful to have an idea of what the earnings pre-tax look like compared to the interest expense, but if a lot of the company's gross profit goes to income taxes, that's a huge part of the story that is not getting represented in ICR, and might prevent you from knowing the whole story about a company's financial situation. As a result, some may be more inclined to use earnings before interest after tax (EBIAT) when calculating ICR instead of EBIT to show a different side.
ICR also isn't necessarily consistent from industry to industry, and some industries can be more volatile than others. Standards for what is and is not an acceptable ICR can vary as a result. As such. interest coverage ratio is best treated as one of several tools one should use when judging how risky an investment is.