Interest Coverage Ratio
Description: The interest coverage ratio measures the ability of a company to pay the interest on its outstanding debt. A high interest coverage 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.
Formula: Divide earnings before interest and taxes (EBIT) by the interest expense for the measurement period. The calculation is:
Earnings before interest and taxes
Example: 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:
$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.
Cautions: A company may be accruing an interest expense that is not actually due for payment yet, so the ratio can indicate a debt default that will not actually occur, until such time as the interest is due for payment.
The interest coverage ratio is also known as times interest earned.