What Is the Interest Coverage Ratio?
The interest coverage ratio measures how easily a company can pay the interest on its outstanding debt out of its operating earnings. It answers a simple question for lenders: if profits dip, how much cushion is there before the company can no longer afford its interest bill?
A higher ratio means more safety. Investment-grade companies often cover their interest many times over, while highly leveraged companies may cover it only two or three times, leaving little room for error.
Formula
The classic version is Interest Coverage Ratio = EBIT / Interest Expense, where EBIT is earnings before interest and taxes. Credit analysts also commonly use EBITDA / Interest Expense, which adds back depreciation and amortization to approximate cash operating earnings.
The EBITDA version produces a higher, more flattering number, so it matters which one a loan covenant or bond document specifies. Both are usually calculated over the trailing twelve months.
Example
Suppose a company generates $240 million of EBIT and pays $60 million of annual interest on its debt. Its interest coverage ratio is $240 million / $60 million = 4.0x, meaning operating profit could fall by 75 percent before the company could no longer cover interest from earnings. If a recession cut EBIT to $90 million, coverage would drop to 1.5x and lenders would start paying very close attention.
Why It Matters
Interest coverage is one of the first ratios credit analysts, rating agencies, and leveraged finance bankers check, because a company that cannot cover its interest is on the road to default. Coverage covenants in loan agreements often require borrowers to keep the ratio above a set level, and breaching one is a technical default.
The ratio also disciplines deal-making: in an LBO model, the amount of debt a buyer can layer onto a target is limited in part by how much interest the target's cash flows can safely cover.
