Understanding the Interest Coverage Ratio (ICR)

The Interest Coverage Ratio (ICR) is a financial ratio that measures a company's ability to pay interest expense on its outstanding debt. It is calculated by dividing the company's earnings before interest and taxes (EBIT) by its interest expense during a given period. A higher ICR indicates that a company is better able to meet its interest obligations.

Given Financial Information

Let's list the key financial details provided for the company:

• EBIT (Earnings Before Interest and Taxes) = Rs. 35 lakhs
• 15% Term loan = Rs. 50 lakhs
• Working capital term loan from bank @ 20% = Rs. 30 lakhs
• 10% Preference share capital = Rs. 10 lakhs (This is preference dividend, not interest expense)
• Public deposits accepted @ 14% = Rs. 15 lakhs

Formula for Interest Coverage Ratio Calculation

The formula to calculate the Interest Coverage Ratio is:

\(\text{Interest Coverage Ratio} = \frac{\text{EBIT}}{\text{Total Interest Expense}}\)

To use this formula, we first need to calculate the total interest expense.

Calculating Total Interest Expense

Interest expense arises from debt. We need to calculate the annual interest payment for each source of debt mentioned:

• Interest on 15% Term loan: \(15\% \times \text{Rs. } 50 \text{ lakhs} = 0.15 \times 50 = \text{Rs. } 7.5 \text{ lakhs}\)
• Interest on Working capital term loan @ 20%: \(20\% \times \text{Rs. } 30 \text{ lakhs} = 0.20 \times 30 = \text{Rs. } 6 \text{ lakhs}\)
• Interest on Public deposits accepted @ 14%: \(14\% \times \text{Rs. } 15 \text{ lakhs} = 0.14 \times 15 = \text{Rs. } 2.1 \text{ lakhs}\)

Note that the 10% Preference share capital represents preference dividends, which are paid after interest and taxes, and therefore are not included in the interest expense calculation for the Interest Coverage Ratio.

Total Interest Expense = Interest on Term loan + Interest on Working capital loan + Interest on Public deposits

Total Interest Expense = Rs. 7.5 lakhs + Rs. 6 lakhs + Rs. 2.1 lakhs = Rs. 15.6 lakhs

Calculating the Interest Coverage Ratio

Now we can plug the values of EBIT and Total Interest Expense into the formula:

\(\text{Interest Coverage Ratio} = \frac{\text{EBIT}}{\text{Total Interest Expense}}\)

\(\text{Interest Coverage Ratio} = \frac{\text{Rs. } 35 \text{ lakhs}}{\text{Rs. } 15.6 \text{ lakhs}}\)

\(\text{Interest Coverage Ratio} \approx 2.243589...\)

Rounding this to two decimal places, we get approximately 2.24.

Summary of Calculation Steps

Based on the calculations, the Interest Coverage Ratio for the company is approximately 2.24.

Revision Table: Key Financial Ratios

Additional Information: Importance of Interest Coverage Ratio

The Interest Coverage Ratio is a crucial metric for creditors and investors. It provides insight into the company's financial health and its risk of default on interest payments. A low ICR suggests that a company may struggle to meet its debt obligations, especially if earnings decline. A high ICR indicates a strong ability to handle debt interest payments. The acceptable level for an ICR varies by industry, but a ratio significantly below 1.5 or 2 might be considered risky. Regulators and loan agreements often specify minimum ICR requirements that companies must maintain.