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Interest Coverage Ratio
Definition of
Interest Coverage Ratio
What is the Interest Coverage Ratio? The Interest Coverage Ratio (ICR), also known as the Times Interest Earned (TIE) ratio, is a solvency ratio used to determine how easily a company can pay interest on its outstanding debt. It is calculated by dividing a company's Earnings Before Interest and Taxes (EBIT) by its interest expenses for a given period. A higher ratio indicates a better ability for the company to meet its interest obligations.
Activities Related to
Interest Coverage Ratio
Here is a list of activities related to the Interest Coverage Ratio: Calculating EBIT from the Income Statement. Identifying total interest expenses for the period. Dividing EBIT by the interest expense to get the ratio. Analyzing the ratio to assess the company's financial risk related to its debt. Comparing the ratio to industry benchmarks and historical trends. Using the ratio by lenders to evaluate creditworthiness before loan preparation and approval. Making strategic decisions about debt levels and financing based on the company's ability to cover interest payments.
The Importance of
Interest Coverage Ratio
The Interest Coverage Ratio is important because it indicates a company's margin of safety for paying interest on its debt. A low ratio (typically below 1.5 or 2) suggests that a company may have difficulty meeting its interest payments if earnings decline, potentially leading to financial distress or bankruptcy. A higher ratio provides more comfort to lenders and investors that the company can handle its debt obligations. It's a key indicator of a company's short-term financial health and solvency. Understanding this ratio is part of sound financial planning.
Key Aspects of
Interest Coverage Ratio
Measure of Solvency
Indicates the ability to service debt interest payments.
Higher is Better
A higher ratio generally signifies less risk for lenders and investors.
Uses EBIT
Focuses on operating earnings available to cover interest before taxes are considered.
Lender Scrutiny
Closely watched by creditors and bondholders to assess default risk. An important metric during loan preparation.
Concepts Related to
Interest Coverage Ratio
The Interest Coverage Ratio is a type of Solvency Ratio, which is part of the broader category of Financial Ratios. It uses data from the Income Statement, specifically EBIT and interest expense. It's related to other debt management ratios like the debt-to-equity ratio. Accurate bookkeeping is essential for providing the correct figures for its calculation. This ratio is often analyzed in our Performance Ratios report.
Interest Coverage Ratio
in Action:
The Adventures of Coco and Cami
Coco took out a loan to buy her new oven and now has to make monthly interest payments. Professor A introduces the Interest Coverage Ratio to show how many times her bakery's operating profit (EBIT) can cover those interest payments. A higher number means she can easily afford them!
Cami, who also has some business debt, uses the ratio to ensure her boutique is earning enough to comfortably handle its interest expenses. This helps them both manage their financial obligations and keep their businesses healthy.