The Interest Coverage Ratio (ICR) Explained

The Interest Coverage Ratio (also known as the Times Interest Earned Ratio) is used to determine a company’s ability to pay interest on its outstanding debt using its operating profits.

In simpler terms, you can consider it a safety buffer that a company has for its interest payments during a given period of time, essentially being a frontline defense against businesses that generate just enough cash to service their debt but not enough to grow or return capital to its shareholders.

The ICR Formula

The calculation is straightforward:

Interest Coverage Ratio = EBIT / Interest Expense

EBIT (Earnings Before Interest and Taxes) represents operating profit before financing and tax costs. Dividing EBIT by interest expense shows how many times over current earnings can meet debt servicing costs.

In some industries which have large non-cash expenses, such as Telecommunications, Manufacturing, or Energy, analysts will often replace EBIT with EBITDA (adding back Depreciation and Amortization).

EBITDA-based ICR offers a view of raw operating cash generation, while EBIT-based ICR remains the stricter solvency test.

Many professional investors calculate both to understand best-case and worst-case coverage scenarios.

What Does a Good ICR Ratio Look Like?

While there is certainly no universal benchmark when it comes to determining a good ICR ratio, there are nonetheless some widely accepted ranges that you can use to help you determine the health of a company, which we’ll outline in the table right below:

What ICR Doesn't Reveal

While ICR is obviously quite powerful, it still has some notable limitations, or blind spots, which is why it is not considered a complete diagnostic tool.

The first notable issue has all to do with principal, as ICR measures just the cost of the debt, and not repayment of the debt. Because o this, a company can have a solid interest coverage ratio but still go bankrupt if it cannot pay the principal due next month.

The second blind spot can occur when companies which see their customers not actually paying the bills, or simply those with high accounts receivable, can run out of cash despite a high ICR.

In your analysis, we recommend that you always pair ICR with the Debt Service Coverage Ratio (DSCR) and Free Cash Flow (FCF) to see if the earnings are actually turning into bankable cash. 

Why ICR is Matters Today

In today’s markets, ICR is proving to be more and more important, due to the reasons below:

The Refinancing "Maturity Wall"

Many corporations are currently hitting a "maturity wall," where debt taken out at 2% or 3% in the early 2020s must be refinanced at 6% or 7%. 

Even if a company’s EBIT stays the same, their Interest Expense is doubling, which slashes their ICR in half overnight.

Credit Rating Pressure

ICR is the primary input that credit rating agencies like S&P use for ratings, and these agencies will usually downgrade companies with a falling ICR, which in turn leads the affected companies to increase borrowing even further. 

This creates a death spiral, and is something that you should always keep a mind on.

Dividend Sustainability

This serves as an early warning for income investors, as a company’s ICR will almost always decline before it cuts its dividend. For example, if you see a company that has an ICR below 2.0x, the 5% dividend yield is most likely at risk.

Final Thoughts

As you can see, you can succesfully utiliez IRC to gauge the health of a company you want to or are already inesting in, with those companies that prioritize balance sheet quality over top-line growth having the most long-term success.