Why an Interest Coverage Ratio of 3 is preferable over 2 for equity investors?

Equity investors generally prefer a higher interest coverage ratio, as it indicates a company's ability to comfortably meet its interest payment obligations. A ratio of 3 is often seen as more favorable than a ratio of 2.

The interest coverage ratio (ICR) is a financial measurement that shows how well a company can handle its debt payments. It is calculated by dividing the company's earnings before interest and taxes (EBIT) by its interest expense. This ratio gives valuable information about the company's financial well-being. Creditors and shareholders use this ratio differently since they have different interests and positions within the company's capital structure.

The interest coverage ratio formula is calculated as follows:

Interest Coverage Ratio = Earnings Before Interest & Tax / Interest Expenses

Creditors, like bondholders and lenders, prioritize the safety and security of their investments. For them, an interest coverage ratio of more than 2 is a positive sign, indicating that the company generates enough earnings to easily cover its interest payments. This lowers the risk of default and signals financial stability, which is reassuring for creditors. As a result, creditors tend to view a company with a robust interest coverage ratio more favorably, as it suggests a reduced risk of credit losses.

Equity shareholders, like common stockholders, want chances for higher returns on their investments. They may not find an interest coverage ratio of more than 2 as favorable as creditors. While a strong interest coverage ratio shows financial stability, it also means the company uses a significant portion of its earnings to pay off debt, leaving less for dividends or retained earnings for shareholders. Equity shareholders usually prefer an ICR above 3, but not below 2. The reason of this we will explore in following example.

An interest coverage ratio of 2 is often considered satisfactory for investors. However, it may not generate sufficient returns for shareholders. Let's examine this further:

In the above-given table, we have information about the interest coverage ratio (ICR), earnings before interest and taxes (EBIT), interest payments to lenders, taxes, and earnings for shareholders. When the ICR is 1, all the earned value goes to the lenders as it equals the interest expense. When the ICR is 2, which is the minimum limit for shareholders, the lenders get 50 units, and the shareholders get 35 units. This shows that if the shareholders take more risk compared to the creditors, they are earning less. This risk-reward ratio seems unfavorable, making the company more attractive for lending rather than equity investment. However, when the ICR is 3 or 4, the risk gets minimized, and the potential for returns is maximized. That's why it is recommended that the ICR should be more than 3, not 2.

Disclaimer: The article is for informational purposes only and not investment advice.