Importance & limitation of Interest Coverage Ratio – Numerous financial metrics, such as the ICR, act as a test on an organization’s solvency. Companies, investors, and financial analysts may use it to quickly determine a company’s current capacity to cover off the accrued interest on a mortgage.
It is a financial ratio that could be used to determine how many years a firm can cover off its interest from its present revenue before taxes and interest are excluded.
In layman’s terms, the ICR is a calculation that determines how quickly a company can pay off its share of debt interest expenditures. It is also recognized as the ‘times interest earned’ ratio.
Must Read – What Is Interest Coverage Ratio?
It should be remembered that such a ratio is not dealing with repaying the principal debt sum. The ICR is solely concerned with a company’s capacity to pay interest on its loans.
Importance of Interest Coverage Ratio
These are some of the most popular applications of this ratio.
- A careful examination of the ICR provides a greater understanding of a company’s profitability whenever it applies to interest on debt pay-outs or defaults.
- It enables creditors to assess a business’s creditworthiness prior to actually lending credit to it. They like companies with a strong ICR.
- This ratio is used by stakeholders such as creditors, staff, and investors to assess the company’s productivity. As a result, they are able to make appropriate decisions.
- It is useful for determining a company’s financial security and fitness in the short term.
- This ratio’s trend analysis provides useful information into a business’s profitability whenever it applies to paying back interest.
Individuals should be aware of the limitations of such a financial metric in order to render the most of it.
Limitation of Interest Coverage Ratio
An ICR, like all other ratios, is difficult to predict a business’s long financial position.
Aside from that, the following highlights the ratio’s limitations.
- It does not take into account seasonal variables that have the potential to skew the ratio. As a consequence, it does not have a complete picture of a company’s financial situation.
- This ratio doesn’t really account for the effect of Tax Expenditure on an organization’s cash flow.
- Since interest coverage for firms in various sectors varies greatly, this is not the easiest way to measure their success or viability.
- Some loans may be excluded or isolated by businesses when calculating this ratio.
One must use the ICR in conjunction with other metrics such as the quick ratio, current ratio, cash ratio, debt to equity ratio, and so on when analyzing a company’s financial results. This will assist in maximizing the advantages of the above metric and successfully minimizing its weaknesses. Besides that, prior investing in or lending capital to a specific firm, other variables must be considered.