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Interest service coverage ratio (ISCR) essentially calculates the capacity of a borrower to repay the interest on borrowings. It is also known as Interest Coverage Ratio or Times Interest Earned. ISCR less than 1 suggests the inability of firm’s profits to serve its interest on debts and obviously the debts. ISCR is a tool for financial institutions to judge the capacity of a borrower to repay the interest on the loan.
Interest Coverage Ratio (ICR) is one of the leverage / coverage ratios which is calculated in order to know the cash profit availability to repay the interest on debts. Generally, ICR is determined when a firm / business borrows a loan from bank / financial institution / any other loan provider.
This ratio explains the ability of cash profits to meet interest payment of the loan. It is an important ratio for financial analysis of a business or firm especially from the viewpoint of a lender because the ratio indicates the repayment capacity of paying interest by the borrower.
To have some concrete results, this ratio needs to be calculated for the entire period of a loan. It is evident in the moratorium period which is the
initial period in which cash inflows are sufficient and even a very good borrower with great credibility will also not be able to service the interest as well as the principle amount.
How to calculate Interest Coverage Ratio?
It is calculated with the help of a very simple formula. In order to calculate the ratio, following items from the financial statement are required:
- Profit before interest and tax (PBIT)
- Noncash expenses (e.g. Depreciation, Miscellaneous expenses are written off etc.)
- Interest for the current year
Sometimes, these figures are readily available but at times, they are to be determined using the financial statements of the company / firm.
Formula for Interest Service Coverage Ratio is stated as follows:
Interest Service Coverage Ratio (ISCR) =
PBIT + Noncash expenses
Profit before Interest and Taxes (PBIT)
PBIT is easily available in the Profit and loss account. Just find out the PAT which is readily available on the face of the profit and loss statement. From the PAT, deduct the income tax and interest and the result is PBIT.
The amount which is paid or payable for the financial year under concern on the loan taken.
Noncash expenses are those expenses which are charged to the profit and loss account for which payment has already been done in the past years. Following are the non-cash expenses:
- Writing off of preliminary expenses, pre-operative expenses etc,
- Depreciation on the fixed assets,
- Amortization of the intangible assets like goodwill, trademark, patent, copyright etc,
- Provisions for doubtful debts,
- Deferment of expenses like an advertisement, promotion etc.
Interpretation of interest service coverage ratio
Calculation of ISCR is a child’s play but it makes sense only when it is interpreted in the right sense. The result of an interest service coverage ratio is an absolute figure. Higher this figure better is the interest serving capacity. If the ratio is less than 1, it is considered bad because it simply indicates that the profits of the firm are not sufficient to service its interest obligations leave apart the debt obligations.
As per industry norms, the ratio should never be less than 2.5 as it is an absolute danger signal. The ratio is most utilized by lenders such as banks, financial institutions etc. Broadly there are two objectives of any lender behind extending a loan to a business which is earning interest and securing the principle too.
Let’s take an example where the ISCR is coming to be less than 2.5, which directly indicate negative views about the capacity of a firm to repay the interest. Does this mean that the bank should not extend loan? No, absolutely not. It is because the bank will analyze the profit generating capacity and business idea as a whole and if the business is strong in both of them; the ISCR can be improved by increasing the term of the loan and providing the moratorium period in which no payments are due for the borrower.