The interest coverage ratio or ICR is a financial ratio of a company. It helps us to understand if the company is economically strong or not. If we analyze this ratio of a company, we can easily see their growth which they have done year by year. Whenever a company needs to expand its business, it went to a bank for debt. Then the bank checks and calculates the ICR before giving the company that loan. In the following passage, we are going to understand the basics of the concept. We shall also try to analyze how a company’s ICR is been calculated and how it is going to help us for our future investments in the stock market.
FAQ about the Interest Coverage ratio
The minimum interest coverage ratio of a company should be two. It shows that the company can make its interest payment back twice.
If a company does not have the minimum interest coverage ratio of two and it is less than one. It means the company will not able to pay their interest money back. It also suggests that the company is not doing well financially.
The benchmark for interest coverage ratio is 2 that considered as least acceptable rate according to a standard guideline. This percentage is only acceptable for few companies, especially the big cap ones.
Intuitively, a lower ratio indicates that there are very few operational earnings available to cover interest payments, making the company more exposed to interest rate fluctuations. As a result, a greater interest coverage ratio implies that the company is in better financial shape and can satisfy its interest commitments.
Definition of Interest Coverage ratio / ICR
It is the earning before interest and taxes (EBIT) of a company is divided by an interest-paying amount. The rate we got is generally known as the interest coverage ratio or ICR. This ratio suggests how many times the company can comfortably pay its interest amount. Usually when a company wants to expand their business but they do not have sufficient capital they contact a bank for a debt. They make a deal with the bank. The bank will give them funds which the company will use for their business development and company purposes. At the year ending the company will pay the bank their interest amount.
Let us take an example
Here, we take the example of “Adani Power Ltd”. The company’s annual EBIT is 7415cr rupee and its yearly interest amount is 5106cr rupee. These two amounts are highlighted by pink (EBIT amount) and green (interest amount) in the above chart. Now, we divide the EBIT amount by the interest amount and we get the 1.45 interest coverage ratio. The data clearly indicates that the company can cover its interest amount only one time. It also suggests the company may be going under loss. If we invest our money in that company shares it might not gonna be profitable for us in long run.
Interest Coverage ratio formula with description
To analyze a company’s interest coverage we need the formula. In which we shall put all the amount and we will get the ideal ICR without any problem. The formula is ICR= EBIT/ Interest Expenses,
Above the picture, there is a clear view of 1st formula. Suppose “RTR Ltd” is a company whose EBIT is 400cr annually and that company’s interest amount is 100cr. Now we divide the (400/100), we get 4. It is considered as a decent interest coverage ratio of a company. The bank or any other company’s fund manager always checks this ratio before giving any kind of fund.
Analyze Interest Coverage ratio
We can easily analyze a company’s yearly situation by using the interest coverage ratio. But we need to know how to use this ratio to analyze a company’s growth. In the following, I have analyzed two situations. So that my readers could understand it without any issue.
Company with high-interest coverage ratio
The company usually takes a loan from a bank to develop their business. So that they could expand their business. The company could make more profit out of their business. The yearly earnings before interest and taxes show how much money the company had made after one year. Now, we have to divide this money by the interest amount a company has to pay yearly to the bank. If the ratio comes out more than 2 or 3, it means the company is in a safe situation, and if that interest ratio rises year by year. It means the company is growing more and more in the years.
Company with low-interest coverage ratio
On the other hand, if the company doesn’t do good business that year. Then, it’s quite clear that the company is not able to pay that interest money. That company’s interest coverage rate would decrease. If that decreased by 1.5 % or less than that. It means the company is going through a tough situation. There are some rumors also that the company is undergoing a big loss. In such a situation, the bank will not give any more loan to that company. The bank even can try to recover its money.
Low IRC shows company’s fall
Suppose a company has taken a loan of rupees 5 lakh and they have to pay an interest amount of 1 lakh each year. Now, the company has to earn more than 1 lakh. So that they can pay that interest without any hesitation or problem. But in any case, that company doesn’t make EBIT more than one lakh at the year ending. Then it is quite clear that the company is unable to pay their interest for that year and if this happens year after year, it means something is cooking in the company’s background. Their shares are no longer profitable to invest in.
The Panjab National Banks downfall is quite visible through the share chart and their low-interest coverage ratio with the high-interest amount. Those two ratio shows that the bank is going through a rough time.
High IRC shows company’s growth
On the other hand, suppose a company named “ABC Ltd” has taken a debt of 5 lakh from a bank. They have to pay 1 lakh rupee interest per annum. Now, the company is making 3 to 5 lacks EBIT annually. That means the company will easily and comfortably pay their interest rate more than once, and if they keep growing that interest coverage rate year by year. That suggests that the company is growing bit by bit. The company is using its debt very well and has potential in it. The “ABC” company is going to be a multi-millionaire company shortly. It is going to be a profitable business for the bank as well. Through 3 to 4 years’ growing interest coverage ratio, we can analyze that it is profitable for the traders and investors to invest in that company’s shares.
Bhansali Engineering Polymers Ltd is growing year by year. That is visible by the share chart and Its company’s interest coverage ratio. Because its ICR data is very high.
This chart also suggests that the company is growing year by year and they also utilizing their debt quite well. That is quite visible in their trading chart.
Interest Coverage Ratio’s Limitations
The interest coverage ratio is like any other indicator. That used to assess a company’s efficiency. But this concept has several limitations that any investor should be aware of before utilizing it. While examining organizations in different industries, or even within the same industry, it’s crucial to keep in mind that interest coverage varies significantly. An ICR value of two is often an acceptable standard for established corporations in some industries. Such as a utility company but not for the manufacturing companies. Car sales plummeted during the 2008 crisis. That created havoc on the auto manufacturing industry. Unexpected events such as a workers’ strike can also cause problems on the books. Because these businesses are more susceptible to these variations. They must rely on a higher ability to cover interest to accommodate for periods of poor revenues.
- Praveen Kataria, Kanti Lal Kataria, Arvind Kataria, Anil Kumar Mehta, Madhubala Jain are the Directors of “D P Wires Limited”. This company was formed on 26th February in 1998. Initally, the company was trying to establish their foot on the wire industry. But now, they have rooted in the field of wire industry very well. That their company is well-known in the wire sector.
- There is a government company named “NMDC” founded on 15th November 1958. Its headquarter is in Hyderabad. It comes under the ministry of steel. Its ICR is 530 and its EBIT is 8913cr. When we divide it by the interest amount of 16.8cr, the interest coverage shows the company is in a good situation. Because the company can pay its interest coverage comfortably. Its EBIT (earnings before interest and taxes) is so high and the annual interest-paying amount is so low that they can cover their interest coverage ratio without any problem. that also suggests the company is in a good situation economically.
After all this analysis, I hope my readers have a clear view of the Interest Coverage Ratio. Not only the fund manager but we can also calculate the ICR of a company using this formula. So that it will be easy for us to understand if we should invest our money in that company’s share or not. This is a reliable indicator of a company’s short-term financial health in general. While evaluating a company’s interest coverage ratio history to make future estimates may be a smart technique to assess an opportunity to invest. It is impossible to reliably anticipate a company’s long-term financial health with any ratio or measure.