## Definition of Interest Coverage Ratio

The term “interest coverage ratio” (ICR) refers to the financial ratio that assesses a business’s capability to pay off its financial costs by using its operating profit. In other words, it measures how well a company is able to cover the interest payment on its debt. Please note that the calculation does not include principal repayment obligations.

**Formula**

The formula can be expressed as operating profit or earnings before interest and tax (EBIT) divided by the interest expense. Mathematically, it is represented as,

**Interest Coverage Ratio = EBIT / Interest Expense**

**Examples of Interest Coverage Ratio (With Excel Template)**

Let’s take an example to understand the calculation in a better manner.

#### Example #1

**Let us take the example of a manufacturing company to illustrate the computation of the (ICR). The company achieved revenue of $35.5 million during 2018, while it incurred the raw material cost and direct labor cost of $12.2 million and $5.5 million, respectively. The rental expense, depreciation, and salaries for the period are $0.7 million, $1.5 million and $3.7 million, respectively. Calculate the company’s interest coverage ratio if its interest expense for the year was $2.2 million.**

**Solution:**

COGS is calculated using the formula given below

**COGS = Raw Material Cost + Direct Labor Cost**

- COGS = $12.2 million + $5.5 million
- COGS =
**$17.7 million**

Operating Expenses is calculated using the formula given below

**Operating Expenses = Rental Expense + Depreciation + Salaries**

- Operating Expenses = $0.7 million + $1.5 million + $3.7 million
- Operating Expenses =
**$5.9 million**

Operating Income (EBIT) is calculated using the formula given below

**EBIT = Revenue – COGS – Operating Expenses**

- Operating Income (EBIT) = $35.5 million – $17.7 million – $5.9 million
- Operating Income (EBIT) =
**$11.9 million**

It is calculated using the formula given below

**Interest Coverage Ratio = EBIT / Interest Expense**

- = $11.9 million / $2.2 million
- =
**5.4x**

Therefore, the company’s (ICR) for the year 2018 was 5.4x.

#### Example #2

**Let us now take Apple Inc.’s example to explain the calculation of (ICR). During 2018, Apple Inc. booked $70.90 billion as operating income, while it incurred $3.24 billion as interest expense. Compute Apple Inc.’s interest coverage (ICR) based on the given information.**

**Solution:**

It is calculated using the formula given below

**Interest Coverage Ratio = EBIT / Interest Expense**

- = $70.90 billion / $3.24billion
- =
**21.88x**

Therefore, Apple Inc.’s (ICR) for the year 2018 was 21.9x.

**Source Link: Apple Inc. Balance Sheet**

#### Example #3

**Now, let us take the example of Walmart Inc. and compute it (ICR). The company recorded an operating income of $20.44 billion during 2018. Compute Walmart Inc.’s interest coverage ratio for the year 2018 if the interest expense incurred was $1.98 billion.**

**Solution:**

Interest Coverage Ratio is calculated using the formula given below

**Interest Coverage Ratio = EBIT / Interest Expense**

- = $20.44 billion / $1.98 billion
- =
**10.3x**

Therefore, Walmart Inc.’s (ICR) for the year 2018 was 10.3x.

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**Source Link: Walmart Inc. Balance Sheet**

#### Example #4

**Now, let us take the example of Samsung Electronics Co. Ltd.’s annual report for the year 2018. As per the annual report, the year’s operating profit and financial expenses were $53.52 billion and $7.82 billion, respectively. Compute Samsung’s interest coverage ratio for the year 2018.**

**Solution:**

Interest Coverage Ratio is calculated using the formula given below

**Interest Coverage Ratio = EBIT / Interest Expense**

- = $53.52 billion / $7.82 billion
- =
**6.8x**

Therefore, Samsung’s (ICR) for the year 2018 was 6.8x.

**Source Link: Samsung Inc. Balance Sheet**

### Explanation

The formula can be derived by using the following steps:

**Step 1:** Firstly, determine the operating profit booked by the company during the given period, usually a year, which is available as a separate line item in the income statement. If not, then EBIT can be computed by subtracting the cost of goods sold (COGS) and operating expenses from revenue.

**EBIT = Revenue – COGS – Operating expenses**

**Step 2:** Next, determine the company’s interest expense on its debt during the given period. It is either available as interest expense or financial cost in the income statement.

**Step 3: **Finally, the formula for (ICR) can be derived by dividing the operating profit (step 1) by the interest expense (step 2) as shown below.

**ICR = EBIT / Interest Expense**

### Relevance and Use of Interest Coverage Ratio

The concept of (ICR) is very important as it is used to assess a company’s capability to pay its interest obligations. A higher value (more than 2.0x) indicates that the company can comfortably meet its interest expenses. On the other hand, a lower value (less than 1.0x) of (ICR) indicates that the company is not generating adequate operating profit to meet interest payments, which exposes it to the risk of bankruptcy.

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