Why Does a Company’s Interest Coverage Ratio Matter?

Amidst inflationary pressure, rising interest rates are raising the cost of debt for businesses as well as consumers. Companies have historically used debt as a method of financing expansion and growth. However, in the current economic climate, rapidly growing interest payments are turning a helpful tool into a dangerous risk. Interest Coverage Ratios (ICRs) can be a critical but loosely defined metric that could expose businesses to contract disputes if not properly understood.

What is an Interest Coverage Ratio?

An ICR is a commonly used measure to assess a company’s ability to meet its debt obligations. The ratio is usually calculated by dividing earnings before interest and tax (EBIT) by the company’s interest expense.

Whilst what constitutes a ‘good’ ICR ratio varies from industry to industry, the higher the ratio the better, as this indicates the company is in a stronger financial position to meet the costs of its debt.  A higher ICR also indicates that the company has a greater ability to meet potential higher debt financing costs on its debt should interest rates rise in the future.

Why does an Interest Coverage Ratio matter?

Creditors, such as banks, assess a company’s ability to repay its debt when deciding to offer loans or credit facilities. Any perceived risk of inability to repay may affect the line of credit that is available to companies. ICRs are used as a key measure of this risk. Equity investors will also monitor ICRs as a low ratio might raise concerns over future growth prospects and over the company’s ability to pay dividends.

Given their importance, bank loan agreements often include contractual debt covenants by which it is agreed that a company must maintain an ICR above a stipulated level, with failure to do so resulting in contractual penalties or potentially even default.

What are the issues with ICRs?

The fundamental issue with ICRs is that there is no common definition of how an ICR should be calculated. This leads to ICRs being calculated differently by different companies and even single companies calculating multiple different ICRs for different purposes, e.g., different lenders might specify different ICR calculation methodologies within their loan covenants.

In particular, ICRs can differ depending upon the revenue and costs items included in the earnings calculation. Where not clearly defined, this leaves room for interpretation and potential manipulation.

An ICR is not a defined accounting measure, therefore accounting standards do not prescribe how it should be calculated, although guidance as to which revenues and costs might be included in a ICR calculation is given.

What can companies do?

Given the importance of ICRs, and the rising levels of interest rate risk, companies need to be well versed in their individual exposure. Here are the two key questions that companies and their counsel should be asking themselves:

1. Are you exposed? Is a calculation of ICR included in any of your contractual agreements?
2. How are you exposed? How is the ICR calculated? Are the terms clearly defined? Are revenue and costs calculated in compliance with accounting standards?

If there is room for interpretation in how the ICR is calculated, then this leaves the door open for disputes. In an already challenging economic environment this is one problem companies could do without. Fortunately, the solution is straightforward: check your exposure and, if necessary, clarify how the ICR is calculated with reference to the accounting standards, where applicable.