Calculating the ICR involves using earnings before interest and taxes (EBIT) or earnings before interest, taxes, depreciation, and amortization (EBITDA). Recognizing the differences in the calculation methods ensures accurate analysis.
Interest Coverage Ratio Formula
ICR = EBIT ÷ Interest Expenses
A higher ICR indicates a greater ability to meet interest obligations, which is favorable for attracting investors and pleasing creditors.
For a more precise analysis, you can use EBITDA instead of EBIT. EBITDA excludes depreciation and amortization, providing a pure view of cash flow.
While EBIT is the standard, variations exist. EBITDA can sometimes replace EBIT for its cash flow perspective. This is particularly useful in industries with high depreciation and capital expenditure.
Some might annualized quarterly or monthly data for a more accurate yearly perspective. Unlike the typical method, these approaches emphasize different facets of financial health. Understanding these variations also helps match your ICR calculations to specific business contexts or industry practices.
Choosing the right method will affect how you view your company's debt-paying ability and ultimately influence your financial decisions.
Step-by-Step ICR Calculation
1. Determine EBIT: Gather earnings figures from your income statement. Exclude interest and taxes to find EBIT.
2. Identify Total Interest Expenses: Check your financial statements for the interest costs that apply over the period you are reviewing.
3. Apply the Formula: Divide EBIT by your total interest expenses.