You’ve heard the term, “You’ve got to spend money to make money.”
If you’re a small business owner, you know it’s true. But where does that initial money come from? In most cases, people turn to banks for a loan to get their business up and running (or keep them going when the market shifts).
While this debt isn’t a bad thing in business, too much of it can eat into your profits. That’s why knowing how easily you can use your earnings to pay off existing loans is essential, and that’s where the interest coverage ratio comes into play.
But what, exactly, is it? We’ll go over all that and more, so keep reading!
What Is the Interest Coverage Ratio?
The interest coverage ratio measures how easily a company can use its earnings to pay off its debt.
Specifically, the interest coverage ratio (ICR) tells you how many times over your earnings can pay off the current interest on your debt. So, if you have an ICR of 3.5, that means you can pay off your interest 3.5 times over.
This ratio can also be considered a debt or profit ratio or the times interest earned (TIE) ratio, which we’ll dive into later on.
How Is the Interest Coverage Ratio Used in Business?
The interest coverage ratio can give you a quick view of your company’s financial health by telling you how easy it would be to pay off your debt.
It can also help lenders decide how much of a loan you should get.
Potential investors or lenders (such as banks) use this ratio to assess the risks of giving you a loan. Essentially, they want to know how well you can handle your existing payments and outstanding debt before giving you money.
To see how it all works, let’s look at how to calculate your interest coverage ratio.
How Do You Calculate Interest Coverage Ratio?
You can calculate the interest coverage ratio by dividing your company’s earnings before interest and taxes (EBIT) by your interest expense.
Interest Coverage Ratio = EBIT / Interest Expense
Where EBIT can be calculated as:
EBIT = Net Income + Interest + Taxes
You can find net income on your profit and loss statement. Interest and taxes are are listed as expenses on your profit and loss statement.
Interest Coverage Ratio Calculator
While this sounds simple, how do you actually use this formula? Let’s find out via an example.
Interest Coverage Ratio Example
Say you own a construction company and have the following financial information.
- Net income: $48,000
- Tax expense: $12,000
- Interest expense: $40,000
Since we need EBIT in the interest coverage ratio formula, let’s calculate that first.
EBIT = Net Income + Taxes + Interest
EBIT = $48,000 + $12,000 + $40,000 = $100,000
Then, plug the calculated EBIT into the interest coverage ratio formula.
Interest Coverage Ratio = $100,000 / $40,000 = 2.5
For the construction company, you have an interest coverage ratio of 2.5.
But what exactly does that mean?
How To Interpret Interest Coverage Ratio
The interest coverage ratio tells you the number of times your earnings can cover your interest obligations.
In the example, your earnings before interest and taxes can pay for the company’s interest expenses 2.5 times over.
In other words, you have enough earnings (before interest and taxes) to pay off the interest on your loans 2.5 times. This is why it’s also referred to as the times interest earned ratio.
What Does a Higher Ratio Mean?
The higher the ratio, the easier it is for you to pay off your current debts. For instance, if you had a ratio of 5, it would mean your EBIT is enough to cover your interest payments 5 times over.
What Does a Lower Ratio Mean?
A lower ratio means your existing debt is a bigger burden on your company. Specifically, it tells you (and potential lenders) that most of your earnings are going towards debt payments instead of growth.
What Is a Good Interest Coverage Ratio?
Generally, 1.5 is the minimum interest coverage ratio a company should maintain. But many investors would prefer even less risk than that. Typically, lenders and investors want to see an interest coverage ratio of 2 or higher.
Keep In Mind…
…that earnings vary widely between industries. So these benchmarks might help, but they aren’t the end all be all. For instance, utility companies have relatively stable revenue streams and cash flows. In contrast, earnings for restaurants and retail businesses are subject to changes in the market for a given period.
It’s best to only look at companies in your industry. That way, you’re comparing apples to apples and can see if you really need to improve.
Variations on the Interest Coverage Ratio
There’s no single metric that’s going to tell you everything about the financial condition of your business.
When comparing your company’s earnings to its debt, it’s helpful to consider different financial ratios that let you make more liberal or conservative estimates.
There are two common variations of the interest coverage ratio. They’re based on different versions of your earnings.
Ratio Using EBITDA
The first variation of your company’s interest coverage ratio uses earnings before interest, taxes, depreciation, and amortization (EBITDA) instead of EBIT. EBITDA is also known as operating income or operating profit.
Depreciation and amortization are bookkeeping methods businesses use to spread out the cost of long-term assets. Depreciation spreads out the cost of a physical (tangible) asset over time, while amortization does the same for intangible assets (like patents).
For instance, say you buy an excavator for your construction company. It costs $100,000 and has a useful life of 5 years.
Instead of expensing the entire $100,000 up front, you account for the expenses over time. In this case, you can depreciate $20,000 yearly for 5 years.
By using depreciation, you factor in the expense of your long-term assets every year they’re used, which gives you a more accurate picture of the costs of running your business.
If you want to find your depreciation and amortization amounts, they’ll be listed on your income statement under expenses.
How To Calculate Interest Coverage Ratio Using EBITDA
First, we need EBITDA, which is calculated via:
EBITDA = Net income + Interest + Taxes + Depreciation + Amortization
Then, we can calculate the interest coverage ratio by:
Interest Coverage Ratio (using EBITDA) = EBITDA / Interest Expense
Let’s add the $20,000 depreciation expense for the excavator to the previous financials:
- Net income: $48,000
- Taxes: $12,000
- Interest: $40,000
- Depreciation: $20,000
- Amortization: $0
Then, plug these numbers into the above formulas:
EBITDA = $48,000 + $12,000 + $40,000 + $20,000 = $120,000
Interest Coverage Ratio (using EBITDA) = $120,000 / $40,000 = 3.0
Since EBITDA adds depreciation and amortization back to the initial EBIT, you get a larger number in the numerator and a higher interest coverage ratio of 3.0 (instead of 2.5).
Ratio Using EBIAT
The other variation uses earnings before interest after taxes (EBIAT), and it’s more conservative. This ratio tells you how easily you can pay off your company’s debt obligations after you’ve paid your taxes.
You can calculate earnings before interest after taxes using the following formula:
EBIAT = Net income + Interest Expense
When you plug EBIAT into the ratio and use the numbers from the previous example, you get:
EBIAT = $48,000 + $40,000 = $88,000
Interest Coverage Ratio (using EBIAT) = EBIAT / Interest Expense
Interest Coverage Ratio (using EBIAT) = $88,000 / $40,000 = 2.2
This ratio of 2.2 is lower than the first calculation of 2.5, but it’s still in a good range—above 2. It means that after you’ve paid off taxes, you still have enough earnings to cover your debt payments 2.2 times over.
Compared to the other two debt ratios, this one will most likely give you the smallest ratio number.
Assessing Your Finances Using Interest Coverage Ratio
Debt is a necessary part of starting and running most businesses. Just make sure you’re making enough money to pay off your loans and continue investing in business growth.
Your interest coverage ratio can indicate your company’s ability to pay off the interest on your loans. But you’re not the only one who might use this information.
Potential lenders or investors can use the interest coverage ratio when deciding whether to give you new lines of credit. The higher the ratio, the better because it means you have enough money to pay for your current loans comfortably.
Now that you know how the ratio works, grab those financial statements and see where you stand.