What it means
The ratio takes earnings before interest and tax from the income statement and divides it by the interest charged on borrowings in the same period. Both figures come straight from published accounts, which is why the ratio is so widely quoted: it can be calculated by anyone in under a minute.
The output is a multiple rather than a percentage. Its importance comes from the fact that missing an interest payment is a default, and default can end a company far faster than poor trading.
Shareholders can wait for a dividend and suppliers can be asked for extra time, but lenders generally cannot. The ratio therefore acts as an early indicator of whether a capital structure is sustainable.
Loan agreements are where the ratio has the sharpest teeth. A typical facility requires the borrower to maintain the ratio above a set level, tested quarterly on a rolling twelve-month basis, with a breach triggering the lender's right to demand repayment.
Finance teams model the ratio forward through their budget precisely because a breach is expensive even when the business is otherwise fine. Calculating it correctly requires care about definitions.
Interest expense should be the gross figure rather than net of interest received, capitalised interest on construction projects is usually added back, and the earnings figure must be adjusted for one-off items if the ratio is meant to describe underlying capacity. Two analysts using slightly different conventions can produce noticeably different numbers for the same company.
The main nuance is that the ratio measures interest only, not the repayment of the loan itself. A company can show a comfortable ratio and still be unable to refinance a large balloon repayment when it falls due.
For that reason the debt service coverage ratio, which includes scheduled principal repayments, is often used alongside it.
In practice
Real-world examples.
Example
A manufacturing group calculates a ratio of 3.2 times against a covenant floor of 2.5. It decides to defer a discretionary $1,000,000 of capital spending so that a soft quarter cannot push the figure below the limit.
Example
A credit analyst rating two bond issuers finds ratios of 8.1 and 2.3 times. The higher-covered issuer prices its bonds roughly 200 basis points cheaper, which on a $100,000,000 issue saves $2,000,000 of interest a year.
Example
A family business preparing for a bank refinancing recalculates its ratio excluding a one-off legal settlement of $450,000. Underlying coverage rises from 2.6 to 3.1 times, and the bank accepts the adjustment after seeing the supporting documents.
Think of it
“Interest coverage is like checking how many times your paycheck could cover your monthly loan interest payments.
Formula
Calculation
Interest coverage ratio = earnings before interest and tax (EBIT) divided by interest expense. EBIT can be found as revenue minus cost of sales minus operating expenses, or as net profit plus tax plus interest.
Worked example: an equipment hire business reports revenue of $18,000,000, cost of sales of $9,600,000 and operating expenses of $5,250,000, giving EBIT of $18,000,000 - $9,600,000 - $5,250,000 = $3,150,000. Its borrowings total $8,750,000 at an average rate of 8%, so interest expense is $8,750,000 x 0.08 = $700,000. The interest coverage ratio is $3,150,000 divided by $700,000 = 4.5 times. If the company borrowed a further $2,500,000 at the same rate, interest would rise to $700,000 + $200,000 = $900,000 and the ratio would fall to $3,150,000 divided by $900,000 = 3.5 times.Case study
Seen in the real world.
This fictional case is provided for illustration. Corvale Distribution, an invented wholesaler, presented a five-year growth plan to its bank requiring an additional $6,000,000 of borrowing on top of existing debt of $9,000,000. At an average rate of 7.5%, total interest would rise from $675,000 to $1,125,000 a year.
The bank tested the plan against a covenant of 3.0 times. Corvale's forecast EBIT was $4,000,000 in year one, giving coverage of $4,000,000 divided by $1,125,000 = 3.6 times, which looked acceptable until the bank ran a downside case where revenue grew 4% instead of 12%. In that scenario EBIT fell to $3,100,000 and coverage dropped to 2.8 times, breaching the covenant in the second year.
In this illustrative story the parties settled on a phased facility: $3,500,000 released immediately and the balance available only once coverage had been above 3.5 times for two consecutive quarters. Corvale's finance director later described the downside test as the most useful hour the company had spent that year.
Watch out
Common mistakes.
- Netting interest received against interest paid. Lenders generally test gross interest expense, and netting can flatter the ratio enough to disguise a covenant problem.
- Treating a high ratio as proof of financial health. A company with almost no debt will show an enormous ratio while still running out of cash through poor working capital management.
- Forgetting that the ratio ignores principal repayments. Interest may be covered several times over while a large capital repayment falling due next year is entirely unfunded.
Questions
People also ask.
Is times interest earned the same thing?
Yes, times interest earned is simply another name for the interest coverage ratio and uses the same EBIT divided by interest expense calculation.
Should I use EBIT or EBITDA in the ratio?
EBIT is the standard definition, but many loan agreements specify EBITDA because it is closer to the cash available to service debt, so always read the definition in the contract.
What does a ratio below 1.0 mean?
It means operating profit is not enough to cover interest, so the company must fund the shortfall from cash reserves, asset sales or new borrowing, which is not sustainable for long.
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