Interest Coverage Ratio (ICR): What’s Considered a Good Number?

Fact checked by Vikki VelasquezReviewed by Thomas J. CatalanoFact checked by Vikki VelasquezReviewed by Thomas J. Catalano

The interest coverage ratio (ICR) is a financial ratio that measures a company’s ability to handle its outstanding debt. The ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) by the company’s interest expense. A low ICR indicates that the company’s debt is great and, therefore, so is the possibility of bankruptcy. A higher ICR indicates stronger financial health.

ICR is one of many debt ratios that can be used to evaluate a company’s financial condition. A good interest coverage ratio is considered by market analysts, lenders, creditors, and investors because a company cannot grow—and may not even be able to survive—unless it can pay the interest on its existing obligations to creditors. Lenders and creditors may use the ICR to determine the riskiness of lending money to a company; investors may use it to assess the potential of a company.

Key Takeaways

• The interest coverage ratio (ICR) measures a company’s ability to handle its outstanding debt.
• The ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) by the company’s interest expense.
• A higher interest coverage ratio (ICR) means a company is more poised to pay its debts; a low ICR indicates that a company’s debts are great.
• Creditors may use the ratio to decide whether they will lend to the company.
• A lower ratio may be unattractive to investors because it may mean the company is not poised for growth.

What Is an Interest Coverage Ratio (ICR)?

A company’s interest coverage ratio is an indicator of its financial health and well-being; the ratio represents how many times the company can currently pay its obligations using its earnings. The word “coverage” refers to the length of time—usually the number of fiscal years—for which interest payments on that company’s debts can be made with its currently available earnings.

A company with very large current earnings—beyond the amount required to make interest payments on its debt—has a larger financial cushion against a temporary downturn in revenues. A company barely able to meet its interest obligations with current earnings is in a very precarious financial position; even a slight, temporary dip in revenue may render it financially insolvent.

19.26

Amazon’s interest coverage ratio as of August 2024.

Calculating the Interest Coverage Ratio (ICR)

The interest coverage ratio is calculated by dividing earnings before interest and taxes (EBIT) by the total amount of interest expenses on all of the company’s outstanding debts. A company’s debt can include lines of credit, loans, and bonds.

For example, if a company’s earnings before taxes and interest amount to $50,000—and its total interest payment requirements are equal to $25,000—then the company’s interest coverage ratio is two ($50,000/$25,000 = 2).

Important

You can use the formula for interest coverage ratio (ICR) to calculate the ratio for any interest period, including monthly or annually.

Interpreting the Interest Coverage Ratio (ICR)

If a company has a low ICR, there’s a greater chance the company won’t be able to service its debt, putting it at a greater risk of bankruptcy. A low ICR means there is a low amount of profit available to meet the interest expense on the debt. Also, if the company has variable-rate debt, the interest expense will rise in a rising interest-rate environment. 

A high ratio indicates there are enough profits available to service the debt. But, it may also mean the company is not using its debt properly. For example, if a company is not borrowing enough, it may not be investing in new products and technologies to stay ahead of the competition in the long term. 

Optimal Interest Coverage Ratio (ICR)

What constitutes good interest coverage varies not only between industries but also between companies in the same industry. Here’s what analysts generally consider when it comes to this metric:

• An interest coverage ratio of at least two is generally considered the minimum acceptable amount for a company that has solid, consistent revenues.
• Analysts prefer to see a coverage ratio of three (or higher).
• A coverage ratio below one indicates a company cannot meet its current interest payment obligations and, therefore, is not in good financial health.

The Importance of the Interest Coverage Ratio

The interest coverage ratio is an important figure for creditors but also for shareholders and investors. Creditors want to know whether a company will be able to pay back its debt. If it has trouble doing so, there’s less of a likelihood that future creditors will want to extend it any credit.

Similarly, both shareholders and investors can also use this ratio to make decisions about their investments. A company that can’t pay back its debt means it will not grow. Most investors will not want to put their money into a company that isn’t financially sound.

Types of Interest Coverage Ratios

There are a few types of interest coverage ratios. Each serves a different purpose.

• EBIT Interest Coverage Ratio: This metric tells analysts the number of times that a company’s earnings before interest and taxes (EBIT) can pay its upcoming interest expenses. This is calculated by dividing the total interest expense by a company’s EBIT.
• EBITDA Interest Coverage Ratio: Divide a company’s interest expense by its earnings before interest, taxes, depreciation, and amortization (EBITDA) to determine how many times a company’s EBITDA can pay any interest expenses that are coming due.
• EBITDA Less CapEx: Find out how many times a company’s EBITDA can pay its upcoming interest expenses after capital expenditures (CapEx) are deducted. The formula for this type of coverage ratio is (EBITDA – CapEx) ÷ Interest Expense)
• Fixed Charge Coverage Ratio: This metric helps determine a company’s ability to service all of its short- or near-term liabilities. The formula for this type of coverage ratio is (EBITDA – CapEx) ÷ (Interest Expense + Current Portion of a Company’s Long-Term Debt)

Limitations of the Interest Coverage Ratio

A higher interest coverage ratio is usually considered desirable because it means that a company can better fulfill its financial obligations. But, this isn’t always a hard-and-fast rule because this metric can be fluid.

Higher ratios are better for companies and industries that are susceptible to volatility. However, lower coverage ratios are often suitable for companies that fall in certain industries, including those that are heavily regulated. So, it’s important to refrain from comparing companies that aren’t in the same industry. For instance, it’s not useful to compare a utility company (which normally has a low coverage ratio) with a retail store.

What Is the Importance of the Interest Coverage Ratio?

The interest coverage ratio is a financial metric that measures the ability of companies to pay their outstanding debts. The general rule is that the higher the ratio, the better position a company has to repay its interest obligations; lower ratios point to greater financial instability. Analysts generally look for ratios of at least two (2) while three (3) or more is preferred. A ratio of one (1) is not good.

What Does a Negative Interest Coverage Ratio Mean?

A company’s interest coverage ratio can be negative. When this happens, it is under one (1). Companies that find themselves in this situation are not considered financially healthy. As a result, it is generally assumed they won’t be able to keep up with their financial obligations.

How Do You Calculate the Interest Coverage Ratio?

The simple way to calculate a company’s interest coverage ratio is by dividing its earnings before interest and taxes (EBIT) by the total interest owed on all of its debts.

The Bottom Line

Many metrics can help you determine the financial health and well-being of companies and, therefore, your investment portfolio. One of those metrics is the interest coverage ratio. This figure measures a company’s ability to cover its interest obligations. Knowing how to calculate it—and using it alongside other financial metrics—can help you become a well-informed investor and make better decisions about your investments.

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