Is Company's debt a good debt or a bad debt? | Interest cover ratio

If company has debt burden,

Is the amount of debt healthy or unhealthy for the company?

Is the company capable to repay it with interest?

Is the company getting more returns than to be paid as interest?

Such questions are answered by interest coverage ratio

INTEREST COVERAGE RATIO 

Interest Coverage Ratio (ICR) is a solvency ratio that attempts to measure how easily a company can pay its interest expense on outstanding debt. It is used by Bank, Creditors and Prospective Lenders to determine how well a firm can pay its interest on debt. 

How to calculate interest coverage ratio

Interest Coverage Ratio is calculated by dividing EBIT(Earnings Before Interest and Taxes) by interest payment for the given period. 

Some investors and analyst used EBITDA in place of EBIT. There is no specific reason for using EBITDA in place of EBIT, only the non-cash expenses like depreciation and amortization are added. They are just accounting adjustments done to increase the ICR multiple.

EBIT and Interest paid for the period are mentioned in company's P&L statement. In case you don't get EBIT, it is the sum of PAT, Interest and Taxes for the period.

Adding amortization and depreciation expense in EBIT gives EBITDA.

Let us consider a Company X with an annual revenue(EBIT) of 90 Cr. The company is liable to pay 15.6 Cr annually as its interest payment. Applying the formula we get 5.76.

Let us take some realistic example of

Tata Consumers Product Limited-one of the FMCG major in India. As of March 2020, company witnessed an EBIT of 887 Cr with interest expense of 77 Cr. Therefore, interest coverage ratio would be 11.51, which is very impressive.

UNDERSTANDING INTEREST COVERAGE RATIO

If we say that Reliance Industries Limited witnessed an ICR of 4.3 and Dabur India Limited had an ICR of 74.09.

What an investor should understand from such statements?

This statement states that Reliance Industries Limited earned an income that is 4.3 times the amount to be paid as interest. Similarly Dabur India Limited earned 74.09 times of the amount to be paid as interest.

Let us dig deep into ICR

 

What is good Interest Coverage Ratio?

ICR > 3 (greater than 3) is considered the most stable, healthy ICR range. If a company has an ICR of 3, it shows that company earns three times of the amount to be paid as interest. This indicates that company is still profitable after paying its interest expense. 

ICR ranging from 2-3 is considered stable for power sector companies. Institutional investors consider this an alarming situation and they start diluting their stake in the company. This ICR range indicates that company might have solvency issues in the near future.

ICR ranging from 1-2 suggest that company's interest expense is equal to company's earning. At the end of the year, there is no profit remained since most of the company's income is drained away in interest payment. It is an alarming situation for the company as it is on the verge of bankruptcy.

Hence, 

Lower the ICR, more the company is burdened by debt. 

Higher the ICR, easier the company can hold its interest expense.

ICR as solvency indicator 

A continuous increase in Interest Coverage Ratio are good indications for a company. It shows that the company is either increasing its gross profit (EBIT) or decreasing its annual interest expense. 

An increasing ICR indicates company is efficiently using money obtained from debt. Hence, strengthening its solvency.

A continuous decrease in Interest Coverage Ratio are bad indications for a company. It shows that the company is either decreasing its gross profit (EBIT) for increasing its annual interest expense. 

A down falling ICR indicates company is burden by debt and may be unable to pay its interest in future. These are indications for nearing insolvency/bankruptcy. 

USES / SIGNIFICANCE OF DEBT TO EQUITY RATIO 

• ICR is used by Bank, Creditors and Prospective Lenders to determine how well a firm can pay its interest on outstanding debt.
• ICR measures safety margin of a company for paying its interest on debt during a given period.
• ICR tells whether a company is generating money from debt or debt has become a burden on it.
• ICR is an evaluation tool of examining company's financial health.

BENEFITS OF ANALYSING ICR OVERTIME 

• Analysing ICR over time gives investor and understanding of the entry and exit in a business. 
• An overtime increase in interest coverage ratio suggests that company is in strong position of solvency. 
• An overtime dip in interest coverage ratio suggests that company is in week financial position and nearing bankruptcy.
• It is a good evaluation tool for company's financial health so it gives a sight of better investment opportunity. 
• It helps investor understand whether a company is making more money from debt (good debt) or losing money due to debt (bad debt).

INDIAN SECTORS WITH THEIR ICR

Average Interest Coverage Ratio in FMCG Sector: 92.27

Average Interest Coverage Ratio in POWER Sector: 2.20

Average Interest Coverage Ratio in IT Sector: 157.42

This shows that interest coverage ratio differs from industry to industry.

Why such low ICR in power sector and why very high ICR for IT sector?

Generally, power/energy sector has more of tangible asset (i.e. plant, machinery, huge structures) whereas IT company have more of intangible assets.

Payment from customer in power sector is more regular(monthly) basis. Therefore lenders, creditors often considered low ICR for energy sector.

Investomanthan's Advice 

• ICR only comes into play when we compare two companies with debt. 
• Do not compare company with no or very little debt.
• Investors should keep an annual/long term track record of interest coverage ratio which will help you find good investment opportunities.