Interest Coverage Ratio Example

Definition: Interest Coverage Ratio (ICR) is used to assess whether the firm has the ability to pay its interest expense. It determines the number of times interest expense is earned from operating profits. A lower ratio means less earnings are available to meet interest payments and thus the company's debt burden is higher. It is also known as debt service ratio.

Formula:
Interest Coverage Ratio = Net Profit Before Interest and Tax / Interest Charges
Or,
ICR = Earnings Before Interest and Taxes (EBIT) / Interest Expense

Example 1:
MSC Ltd has sales revenue of $88,000. It has cost of goods sold $10,000 and operating expense of $3,000. The firm’s interest expense for the year is $15,000.
Then,
EBIT = Sales – Cost of goods sold – Operating expenses
EBIT = $88,000 - $10,000 - $3,000
EBIT = $75,000

Interest Coverage Ratio = $75,000/$15,000 = 5 times

Example 2:
Bond Ltd has $700,000 in sales revenues; $50,000 in cost of sales; and $30,000 in operating expenses. The fixed interest charges on long-term borrowings are $155,000. Calculate ICR.

Solution:
EBIT = Revenues – (Cost of Sales + Operating Expenses) = 700,000 - (50,000 + 30,000) = $620,000
Interest Coverage Ratio = 620,000 / 155,000 = 4 times

* Next: Earnings Yield Formula & Example