• HDFC securities
• 22 Feb 2023
• Knowledge Centre

 

 

While investing in a firm or business organisation, it is best to ensure that you know its solvency status. Essentially, a company’s solvency status refers to its ability to pay off any piled-up interest and principal amount on the debt. You can use various financial measures to check the same, including Interest Coverage Ratio (ICR). Continue reading to learn more about what Interest Coverage Ratio means and how to calculate it to protect your interests.

What is Interest Coverage Ratio?

The Interest Coverage Ratio (ICR) is a financial metric used to measure a company’s ability to meet its financial obligation of interest payments on its debt. It evaluates whether a company is able to pay off its interest efficiently or also ascertains the number of times a company is capable of paying off any interest using current earnings.

It is expressed in the form of a ratio and is also referred to as ‘times interest earned’. Do note that this ratio does not concern itself with the repayment of principal payments.

A lower interest coverage ratio shows that the company may not be able to meet its interest payments, while a higher ratio is considered to be better as it indicates that the company is able to meet its interest payments.

How is Interest Coverage Ratio Calculated? 

To calculate Interest Coverage Ratio, you simply need to divide the earnings of a company, prior to the payment of interest and taxes, by the interest expenses in the same time period.

Normally this interest coverage formula is used quite often by lenders, investors, creditors, etc. They do so before lending funds to a firm to calculate risks. The Interest Coverage Ratio formula also helps gauge the firm’s profitability.

While you can use this formula to undertake manual calculations, an easier option would be to use an interest coverage ratio calculator. It is an online tool wherein you can enter the pertinent details and the results will be displayed to you almost instantly.

Why is the Interest Coverage Ratio Important?

The interest coverage ratio is important because it helps with the following:

• When you thoroughly analyse a company’s interest coverage ratio, you get a clear idea about its financial stability. This is especially true when it comes to its interest payouts.
• This ratio can also come in handy for lenders who want to evaluate a firm’s creditworthiness before extending any funds. Lenders tend to approve requests from firms that have higher ICR.
• If you are a shareholder in a company, ICR can help you understand the profitability of the corporation. You can use such information to take timely decisions regarding your investments.
• If you want to undertake trend analysis, this ratio provides valuable insight into a company’s ability to repay interest on debts.

All in all, the interest coverage ratio is an excellent metric to use to get an idea of a company’s financial stability in the short term. Do note that it is essential to consider several other factors and financial ratios to make any investment decision.