ICR (interest coverage ratio)

The interest coverage ratio (ICR), in Norwegian rentedekningsgrad, is a key figure showing the business's ability to pay its interest expenses in a given period. By dividing operating profit (EBIT) by the sum of interest expenses in a given period, you get a value that shows the relationship between operating profit and interest expenses, that is, how large a share of operating profit you can expect to be left with once interest expenses have been covered.

How do you calculate ICR?

The interest coverage ratio is calculated by dividing operating profit by interest costs.

ICR = EBIT / Interest costs

EBIT ("earnings before interest and taxes") is the company's operating profit, and includes all income and expenses apart from interest costs and tax, since the ICR key figure assesses the company's ability to cover interest expenses before those expenses have been paid.

Interest expenses include all periodic expenses arising from loans and credit.

What can ICR be used for?

ICR, like the debt service coverage ratio (DSCR), can be used to assess a company's ability to service debt, and its reliability when it comes to loans and credit. Unlike DSCR, ICR can be said to be more oriented towards creditors, since it gives a more detailed picture of whether the company is able to keep up with periodic interest expenses.

An ICR of 1.0 means that operating profit covers the interest expenses exactly, with no margin. If the value is below 1, operating profit does not cover the interest expenses at all. Values between 1 and 1.5 are regarded as vulnerable, since a small fall in earnings is enough for the interest to no longer be covered. An ICR of 2–3 or higher, on the other hand, is regarded as comfortable: operating profit then covers the interest expenses several times over, and that usually means there is little risk for creditors in lending the company money.

A low ICR (a value below 1 or only just above) tells you that a company has a weak ability to generate cash flow to cover interest expenses, meaning the company may be struggling to earn enough money to pay down its debt. In that case it may be less attractive for a creditor to lend the company money. This includes negative values of ICR, which can occur if EBIT is negative, as is often the case in start-up companies.

Tips for increasing ICR

In general it is favourable for a company to have a strong ability to service interest expenses, so a high ICR is desirable. A high ICR value can come either from a high operating profit or from low interest expenses. To increase ICR it is therefore useful to look at opportunities to increase earnings from operations, and to use the surplus to pay down debt in order to reduce the weight of future interest expenses.

1. Efficiency. Evaluate the efficiency of operations.
2. Cut costs. Look at the opportunities to cut costs in the core business.
3. More marketing. Increase the focus on marketing.
4. Focus on specific products. Increase the focus on products or services that sell better than others.
5. Equity. Increase the equity.
6. Cash flow. Focus on increasing cash flow.
7. Revise the budget. Revise the budget for the coming period.
8. Pay down debt. Use a larger share of the surplus to pay down debt.
9. More income sources. Consider the scope for additional income sources.
10. Refinance debt. Consider refinancing the debt.

Advantages and disadvantages

The interest coverage ratio can be a good measure of the risk attached to granting the company a loan or investing in it. It is also a key figure that can be used across industries. The size of operating income and interest expenses varies between companies, but the relationship between the values will usually have the same implications regardless of the company.

The key figure does not, however, take the company's future financial situation into account. It is assumed that the interest expenses a company has had in a given period are constant, which is often not the case. What counts as a favourable ICR value also varies between industries.

Example: ICR and interest expenses

To illustrate ICR, imagine a company with an operating profit (EBIT) of NOK 100,000 and interest-bearing debt of NOK 1,000,000 at an interest rate of 8%. The interest expenses are then NOK 80,000 a year, and ICR = 100,000 / 80,000 = 1.25. Operating profit therefore covers the interest, but with little margin, and the company is vulnerable to a fall in earnings.

The company wants to finance its new investment project with an external loan, but sees that a higher ICR would be favourable in order for creditors to have more confidence in the company. With an expected growth of 5% in operating profit over the next three years, the company has two options: either to continue with the same instalments and wait until operating profit is large enough to outweigh the interest expenses, or to increase the instalments over the next three years in order to reduce the interest expenses and increase ICR more quickly.

If the company chooses the first option and continues to pay NOK 40,000 in instalments each year, the debt is NOK 880,000 after three years, and the interest expenses NOK 70,400. Operating profit has by then grown to NOK 100,000 × 1.05³ ≈ NOK 115,800, and ICR = 115,800 / 70,400 ≈ 1.6. Still vulnerable, but heading in the right direction.

If the company chooses the second option and increases the instalments to NOK 120,000 a year, the debt is down to NOK 640,000 after three years, and the interest expenses NOK 51,200. With the same operating profit, ICR = 115,800 / 51,200 ≈ 2.3, that is, a comfortable level.

Paying down debt therefore reduces future interest expenses and lifts ICR, even though the increased instalments put a strain on liquidity in the period where the repayment is greatest. Note that the instalments themselves do not form part of ICR: the denominator is the interest cost alone. If you also want to take the instalments into account, the debt service coverage ratio (DSCR) is the right key figure.

Read more about how the key figures in Capassa calculate ICR and other debt-related key figures automatically.