Interest Coverage Ratio

What are the two ingredients?

• EBIT is the profit a business makes from its operations, before interest and tax.
• Allianz Trade gives the sum: EBIT = revenue minus (cost of goods sold plus operating expenses).
• Interest expense is the cost of borrowed money. It covers loans, bonds and credit facilities.

How does the RBI define it?

• EBIT means earnings before interest and tax.
• The RBI’s Financial Stability Report (June 2024) defines ICR as the ratio of gross profit (EBIT) to interest expenses.
• So ICR = EBIT ÷ interest expense.
• Allianz Trade gives the same formula.

What does the number say?

• ICR tells you how many times a firm’s earnings can cover its interest bill.
• A higher ratio means a safer cushion for the lender.
• Think of it as a count. An ICR of 3 means earnings could pay the interest three times over.

What is a simple example, step by step?

This is an illustration with made-up numbers.

• Step 1: Firm A earns revenue of ₹500 crore. Its costs of goods and operations come to ₹380 crore.
• Step 2: EBIT = 500 − 380 = ₹120 crore.
• Step 3: Its interest expense is ₹40 crore.
• Step 4: ICR = 120 ÷ 40 = 3. Earnings cover interest three times.

What does a weak firm look like?

• Firm B earns an EBIT of ₹30 crore. Its interest expense is also ₹40 crore.
• ICR = 30 ÷ 40 = 0.75. Earnings do not cover the interest.
• The same loan looks safe for Firm A and risky for Firm B. Only the earnings differ.

What if interest rises?

• Say Firm A’s interest bill doubles to ₹80 crore.
• ICR = 120 ÷ 80 = 1.5. The cushion shrinks from three times to one and a half times.

How do you avoid the flip?

• Earnings go on top. Interest goes below.
• If you divide interest by EBIT, a bigger number now means a weaker firm. That is the opposite of ICR.

What do the rules of thumb say?

• Allianz Trade says a ratio of 2.00 or above is generally considered good.
• It says a ratio below 1.50 should be a red flag.
• It says a ratio below 1.00 means the firm might struggle to meet interest payments.

What does a ratio below 1 really mean?

• Earnings are smaller than the interest bill.
• Think of Firm B above, with an ICR of 0.75.
• The right level also depends on the industry.
• Allianz says manufacturing firms usually need a higher ICR, because they are capital-intensive. Tech firms with less debt often keep lower ratios.

How can a firm improve its ICR?

• Raise EBIT by running operations more efficiently.
• Cut interest expense. Allianz says negotiating better terms or paying down debt can improve the ratio.

The RBI tracks ICR across about three thousand non-financial companies. It reports it in the Financial Stability Report.

Which bands does the RBI use?

• The Financial Stability Report (June 2024) sorts firms by their ICR.
• The bands are ICR at or below 1, above 1 up to 4, and above 4.
• It reports the share of debt held by firms in each band.
• This is a share of debt, not a share of firms.

How did the share with ICR at or below 1 move?

• It was 35.5% in 2016-17 and 37.6% in 2019-20.
• It fell to 21.0% in 2022-23 and 18.0% in 2023-24.
• The data cover 3,073 non-financial companies in 2023-24.
• The RBI calls this share a key indicator of a firm’s financial vulnerability.
• It said the share continued to decline.

Three ratios sound alike. They cover different ground.

What does each one include?

• ICR looks at interest only.
• DSCR (debt service coverage ratio) looks at the ability to cover total debt obligations, including principal repayments.
• DSR (debt service ratio) is defined by the RBI as interest payments plus amortisations, divided by income.

How do you remember it?

• ICR asks, “Can earnings pay the interest?”
• DSCR asks, “Can earnings pay interest and principal?”
• DSR shows what share of income goes to debt service.

Some analysts use a variant. It changes the top line.

What is the EBITDA version?

• Allianz Trade describes an EBITDA interest coverage ratio.
• EBITDA excludes depreciation and amortisation.
• Allianz says this gives a purer view of cash flow.
• The standard ICR, as the RBI defines it, uses EBIT.

What is the limit of ICR?

• ICR only assesses the ability to pay interest.
• It says nothing about principal repayment.
• That is why lenders also look at DSCR.

Think of ICR as an early alarm. It rings before a default.

What is the warning?

• Allianz says a high ICR often indicates financial health.
• When the ratio dips below 1.00, the risk of default rises.
• The RBI watches the debt share of firms below 1 as a sign of corporate vulnerability.

How should you read the fall since 2019-20?

• The share of debt with ICR at or below 1 fell from 37.6% to 18.0%.
• That means less debt sat with firms that could not cover interest.
• It is a sign of better debt-servicing health among these non-financial firms.

Which wrong ideas should you clear?

• Myth: a higher ICR means a riskier firm. Fact: a higher ICR means earnings cover interest more times, so debt service is safer.
• Myth: ICR is interest divided by EBIT. Fact: earnings go on top, so it is EBIT divided by interest.
• Myth: a good ICR means all debts are safe. Fact: ICR looks at interest only. Principal repayment sits in DSCR.

This was Question 62 in the 2020 Civil Services Preliminary Examination (General Studies Paper I, Set A). It asked: “What is the importance of the term “Interest Coverage Ratio” of a firm in India?” It had three statements:

• 1. It helps in understanding the present risk of a firm that a bank is going to give loan to.
• 2. It helps in evaluating the emerging risk of a firm that a bank is going to give loan to.
• 3. The higher a borrowing firm’s level of Interest Coverage Ratio, the worse is its ability to service its debt.

The options were:

• (a) “1 and 2 only”
• (b) “2 only”
• (c) “1 and 3 only”
• (d) “1, 2 and 3”

The answer is (a) 1 and 2 only.

How do you check it?

• Statements 1 and 2 describe what lenders use ICR for: judging how safely a borrower can pay interest.
• Statement 3 is false. A higher ICR means earnings cover interest more times, so the ability to service debt is better.

What should you take away?

• Learn the formula: EBIT divided by interest expense.
• Remember that a higher ICR is safer, not riskier.