How to Calculate and Improve Interest Coverage Ratio?

By Advisorymandi
23-November-2018 11:46:44 AM
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It is extremely important that you must know the process to calculate an interest coverage ratio (ICR) to
determine how safe your investments are in the company and chances of getting back the principal
amount along with the interest on time. Similarly, a company must also know how to improve interest
coverage ratio in order to attract more investments from the creditors and most importantly create positive
sentiment in the stock market. Before beginning with the process of calculating the interest coverage
ratio, let us first know what is it exactly and its importance?

What is Interest Coverage Ratio?
An interest coverage ratio is essentially a financial ratio that helps in measuring the ability of a company
to pay interest on its debts. ICR is of a great prominence to the creditors as it helps them to determine
short-term financial situation of the company. A good ICR is considered to be excellent by the lenders,
investors and market analysts. It is also known as debt service coverage ratio and the times interest earned
ratio.

Interest Coverage Ratio Calculation
The process of calculating interest coverage ratio is quite simple. It is calculated by dividing the
company’s earnings before interest and taxes (EBIT) by the interest expenses for the same period. Interest
expenses are basically the interest which is payable on the borrowings like the bonds, loans, lines of credit
and so on.

Interest Coverage Ratio Formula
Interest Coverage Ratio = Earnings before Interest and Taxes (EBIT) / Interest Expense
How it Works (Example):
Let’s say that the EBIT of a Company XYZ is Rs 20,00,000 and its total interest expenses is Rs
10,00,000, then by using the formula for ICR i.e (20,00,000/10,00,000), we get an ICR of 2.

Ideal Interest Coverage Ratio Level
A question arises here is there any ideal or best interest coverage level through which an individual can
easily determine the financial position of the company? The answer for this question is Yes. If the ICR of
a company is lower than 1, then it indicates that company is under the heavy financial burden and may
find it extremely difficult to pay the debts. Moreover, the companies with the lowest ICR also find it
difficult to get their loan application accepted from the banks. A higher ICR of more than 1.5 is
considered to be better as it clearly signifies that the company is earning good profits and safe for making
an investment.

How to Improve Interest Coverage Ratio?
There is no rocket science behind improving interest coverage ratio. All a company is required to do is to
adequately pay the interest on the debt amount to the creditors on the timely basis. A company cannot
even imagine to survive or grow in the market for the long-term, with the low ICR. On the other hand, if a
company is earning good profits and has an excellent financial cushion, then it signifies that the it will be
able to pay the interest on debts in a timely manner. Hence, if a company, which is hardly able to pay the
debts or its financial position is not good, then in a longer-term, it can lead to the insolvency of the
company. So, paying the interest on debts is a key here to improve interest coverage ratio.
Bottomline
Just by having a look at the interest coverage ratio, you can quite easily determine about the financial

position of the company before you invest. You can actually get a crystal-clear picture about the financial
health of the company after all it is your hard-earned money, which is involved and you do not want to
loose it by investing in the company having a low interest coverage ratio.
Note: All information & data provided in this article is for the educational purpose as well as to give
general information on the finance & economy, not to provide any professional advice or service. Views
& opinions are not biased against the company and do not affect any official policy or any other agency,
an organization within the content.

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Author: Advisorymandi

AdvisoryMandi is India's most trusted Stock Market Advisory marketplace covers NSE, BSE, MCX & NCDEX. Invest with confidence and harness the power of AdvisoryMandi to make smarter investment decisions in Stocks, Indices, Commodities, Forex & IPO.

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