What is Interest Coverage Ratio?

In January 2023, a major sell-off was triggered in most of the Adani group stocks because of a long and detailed report issued by US based short seller Hindenburg Research.

The report questioned the port to power conglomerate Adani group’s debt repayment capacity. Naturally, the report caused a havoc in the market and Adani group stocks witnessed a massive selloff.

Even before this report was released, many experts were already of the view that the group’s debt repayment capacity was dicey and many of the group companies were high debt companies. Now, these experts and Hindenburg research would have used one important metric to arrive at the Adani group’s debt repayment capacity.

The interest coverage ratio is a liquidity ratio that compares a company's earnings, before deducting interest and taxes, with the interest payable on its debts as of the same period.

Lenders, creditors, and experts often use the Interest Coverage Ratio (ICR) to calculate what amount of the company’s existing debt can be paid out of company’s existing earnings before interest, tax, and depreciation (EBIT).

It is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expenses. The resulting ratio indicates how many times a company's operating income can cover its interest payments. Interest Coverage Ratio = EBIT/Interest expense

The ratio acts as a solvency check, using which financial advisors, business analysts and investors can determine the ability of a business or a company to pay off the accumulated interest on the debt they are holding.

There are many benefits of securing finance through debt. Even the most reputed group in India - the Tata group - takes on debt from time to time.

Debt in itself is not bad, it’s the repayment capacity that counts and interest coverage ratio helps in finding this capacity.

An interest coverage ratio of 1.5 is generally considered a minimum acceptable ratio for a company and the tipping point below which lenders will likely refuse to lend the company more money, as the company’s risk for default may be perceived as too high.

If a company’s ratio is below one, it will likely need to spend some of its cash reserves to meet the difference or borrow more, which will be difficult for the reasons stated above. Otherwise, even if earnings are low for a single month, the company risks falling into bankruptcy.

A higher interest coverage ratio is generally viewed as more favorable, as it indicates that a company is generating enough income to easily cover its interest expenses.

While the interest coverage ratio is a useful metric, it does have certain limitations. For example, it only considers a company's ability to pay interest expenses and doesn't take into account other financial obligations such as principal payments or taxes. Additionally, it doesn't provide any information about a company's cash flow or liquidity.

Also, the interpretation of the interest coverage ratio depends on the industry. For example, a company in a capital-intensive industry (such as manufacturing or green energy) may have a lower interest coverage ratio than a company in a less capital-intensive industry. In such cases, it's important to compare a company's interest coverage ratio with those of its peers to get a better sense of how it's performing.

Overall, interest coverage ratio is an important yardstick to understand company’s debt repayment capacity.