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.
The formula for this ratio is to divide earnings before interest and taxes (EBIT) by the interest expense for the measurement period. The calculation is:
Earnings before interest and taxes ÷ Interest expense
For 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:
$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.
If you intend to use this measurement, there is one issue to be aware of. 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.