Tue. Oct 26th, 2021

The interest coverage ratio or ICR is a financial ratio of a company. It helps us understand whether the company is financially strong or not. If we analyze this business ratio, we can easily see their growth that they have done year after year. Whenever a company needs to expand its business, it went to a bank to get debts. The bank then checks and calculates the ICR before granting this loan to the company. In the next excerpt, we will understand the basics of the concept. We will also try to analyze how a company’s ICR is calculated and how it will help us for our future stock market investments.

Frequently asked questions about the interest coverage ratio

What is the minimum interest coverage ratio?

The minimum interest coverage ratio of a company must be two. It shows that the company can repay the payment of its interest twice.

What is considered a bad interest coverage ratio?

If a company does not have a minimum interest coverage ratio of two and is less than one. It means that the company will not be able to return its interests. It also suggests that the company is not doing well financially.

What is the benchmark for the minimum interest coverage ratio?

The benchmark for the interest coverage ratio is 2 which is considered the least acceptable rate according to a standard guideline. This percentage is only acceptable for a few companies, especially large capitalizations.

what type of interest coverage ratio is better or higher?

Intuitively, a lower ratio indicates that there are very few operating profits available to cover interest payments, making the company more exposed to interest rate fluctuations. As a result, a higher interest coverage ratio means that the company is in better financial shape and can meet its interest commitments.

Definition of the interest coverage ratio / ICR

It is the income before dividing the interest and taxes (EBIT) of a company by an amount that pays interest. The rate we have obtained is generally known as the interest coverage ratio or ICR. This ratio suggests how many times the company can comfortably pay its amount of interest. Usually, when a company wants to expand its business but does not have enough capital, it contacts a bank to get a debt. They make a deal with the bank. The bank will give them funds that the company will use for their business development and their purposes. At the end of the year, the company will pay the amount of interest to the bank.

Let’s take an example

Here we take the example of “Adani Power Ltd”. The annual EBIT of the company is 7415cr rupees and its annual interest amount is 5106cr rupees. These two amounts are highlighted in pink (EBIT amount) and green (interest amount) in the graph above. Now, we divide the amount of EBIT by the amount of interest and get the interest coverage ratio of 1.45. The data clearly indicates that the company can only cover its interest once. It also suggests the company could be losing. If we invest our money in shares of this company, in the long run it may not be profitable for us.

Interest coverage ratio formula with description

To analyze the interest coverage of a company we need the formula. In which we will put all the amount and get the ideal ICR without any problems. The formula is ICR = EBIT / Interest Expenses,

Above the image, there is a clear view of the first formula. Suppose “RTR Ltd” is a company with an annual EBIT of 400cr and an interest amount of this company of 100cr. Now we divide the (400/100), we get 4. It is considered a decent interest coverage ratio of a company. The bank or fund manager of any other company always checks this ratio before giving any kind of funds.

Analyze the interest coverage ratio

We can easily analyze the annual situation of a company using the interest coverage ratio. But we must know how to use this ratio to analyze the growth of a company. Next, I analyzed two situations. So that my readers could understand it without any problem.

Company with a high interest coverage rate

The company usually gets a loan from a bank to grow its business. So that they could expand their business. The company could make more profit from its business. Annual earnings before interest and taxes show how much money the company had earned after a year. Now, we have to divide this money by the amount of interest that a company has to pay annually to the bank. If the ratio goes beyond 2 or 3, it means that the company is in a safe situation and if this interest rate increases year after year. It means the company is growing more and more in recent years.

Interest coverage ratio of IOL Chemicals & Pharmaceuties Ltd
“IOL Chemicals & Pharmaceuticals Ltd” has the highest interest coverage ratio.

Company with a low interest coverage ratio

On the other hand, if the company does not do good business that year. Then it becomes very clear that the company cannot pay that interest money. The interest coverage rate of this company would decrease. If this decreased by 1.5% or less than that. It means the company is in a difficult situation. There are also some rumors that the company is suffering a huge loss. In this situation, the bank will not give any more loans to this company. Even the bank can try to get your money back.

Yes, bank interest coverage ratio chart

The low IRC shows the fall of the company

Suppose a company has taken a loan of 5 lakh rupees and has to pay an interest amount of 1 lakh every year. Now, the company has to earn more than a lakh. So that they can pay these interests without any doubt or problem. But in any case, this company does not get an EBIT of more than one lakh in the year ending. Then it becomes clear that the company cannot pay its interest for that year and if this happens year after year, it means that there is something cooking in the bottom of the company. Their shares are no longer profitable to invest in.

Panjab National Bank chart to analyze ICR

The collapse of Punjab’s domestic banks is quite visible through the stock chart and its low interest coverage ratio to the high interest rate. These two proportions show that the bank is going through a difficult time.

The chart of falls of the Panjab National Bank

The high IRC shows the growth of the company

On the other hand, suppose a company called “ABC Ltd” has taken a 5 lakh debt from a bank. They have to pay an annual interest of 1 lakh. Now, the company makes 3 to 5 annual EBIT debits. This means that the company will pay its interest rate easily and comfortably more than once and if this interest rate coverage continues to grow year after year. This suggests that the company is growing slowly. The company uses its debt very well and has potential. The company “ABC” will soon be a multimillion-dollar company. It will also be a profitable business for the bank. By increasing the interest coverage ratio from 3 to 4 years, we can analyze that it is profitable for traders and investors to invest in the shares of this company.

Interest coverage ratio of Bhansali Engineering Polymers Ltd
This company is constantly growing its business and this is demonstrated by the company’s ICR.

Bhansali Engineering Polymers Ltd. grows year after year. This is visible by your company’s stock chart and interest coverage ratio. Because their ICR data is very high.

Commercial chart of Bhansali Engineering Polymers

This chart also suggests that the company is growing year after year and that it is also using its debt quite well. This is quite visible in the trade chart.

Limitations on the proportion of interest coverage

The interest coverage ratio is like any other indicator. It is used to evaluate the efficiency of a company. But this concept has several limitations that any investor should consider before using it. While examining organizations from different industries, or even within the same industry, it is crucial to keep in mind that interest coverage varies significantly. An ICR value of two is usually an acceptable standard for established companies in some industries. Such as a utility company, but not for manufacturing companies. Vehicle sales plummeted during the 2008 crisis. This wreaked havoc on the auto manufacturing industry. Unexpected events such as the workers ’strike can also cause problems in books. Because these companies are more susceptible to these variations. They need to rely on a greater ability to cover interest to accommodate them in periods of poor income.

Example

  • Praveen Kataria, Kanti Lal Kataria, Arvind Kataria, Anil Kumar Mehta and Madhubala Jain are the directors of “DP Wires Limited”. This company was formed on February 26, 1998. Initially, the company was trying to establish its foothold in the wire industry. But now they have taken root very well in the field of wire industry. That your company is well known in the wire industry.
DP Wires
  • There is a government company called “NMDC” founded on November 15, 1958. Its headquarters are in Hyderabad. It is under the Ministry of Steel. Its ICR is 530 and its EBIT is 8913cr. When we divide it by the amount of interest of 16.8 cr, the interest coverage shows that the company is in a good situation. Because the company can pay your interest coverage comfortably. Your EBIT (earnings before interest and taxes) is so high and the annual amount you pay in interest is so low that you can cover your interest coverage rate without any problems. this also suggests that the company is in a good financial position.
NMDC

Conclusion

After all this analysis, I hope my readers have a clear view of the proportion of interest coverage. Not only the fund manager, but we can also calculate the ICR of a company using this formula. So it will be easy for us to understand whether we should invest our money in the share of this company or not. This is a reliable indicator of the short-term financial health of a company in general. While assessing the history of a company’s interest coverage ratio to make future estimates, it can be a smart technique to assess the opportunity to invest. It is impossible to reliably predict the long-term financial health of a company with any ratio or measure.

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