What is the Interest Coverage Ratio?

The interest coverage ratio measures the ability of a company to pay the interest on its outstanding debt. This measurement is used by creditors, lenders, and investors to determine the risk of lending funds to a company. A high ratio indicates that a company can pay for its interest expense several times over, while a low ratio is a strong indicator that a company may default on its loan payments.

It is useful to track the interest coverage ratio on a trend line, in order to spot situations where a company's results or debt burden are yielding a downward trend in the ratio. An investor would want to sell any equity holdings in a company showing such a downward trend, especially if the ratio drops below 1.5:1.

How to Calculate the Interest Coverage Ratio

The formula for this ratio is to divide earnings before interest and taxes (EBIT) by the interest expense for the measurement period. The interest expense portion of this calculation should include the interest associated with short-term debt, long-term debt, and leases. The calculation is as follows:

Earnings before interest and taxes ÷ Interest expense = Interest coverage ratio

Example of the Interest Coverage Ratio

ABC Company earnings $5,000,000 before interest and taxes in its most recent reporting month. Its interest expense for that month is $2,500,000. Therefore, the company's interest coverage ratio is calculated as:

$5,000,000 EBIT ÷ $2,500,000 Interest expense

= 2:1 Interest coverage ratio

The ratio indicates that ABC's earnings should be sufficient to enable it to pay the interest expense.

Related AccountingTools Courses

Business Ratios Guidebook

The Interpretation of Financial Statements

Problems with the Interest Coverage Ratio

There are several problems with the interest coverage ratio to be aware of. They are as follows:

Ignores principal repayments. The interest coverage ratio only uses interest payments; it does not factor in a borrower’s obligation to repay the principal on a loan. This means that the ratio could indicate that a business is stable when that is not really the case.
Ignores cash flow. The interest coverage ratio does not include the borrower’s actual cash flow. If a borrower has strong reported earnings but poor cash flow, then it may not be able to make loan payments, despite reporting a robust ratio.
Ignores interest rate variability. When a borrower has variable-rate debt, its future interest expenses can increase if rates rise, making its current interest coverage ratio less indicative of its future debt servicing ability.
Not a good cross-industry measure. Some industries typically operate with higher debt levels (such as utilities or real estate), making the interest coverage ratio a less meaningful comparison across industries.