Interest Coverage Ratio

The Interest Coverage Ratio shows how well a company can cover its interest burden from its operating result. It compares earnings with interest expense. A high value means that the interest is comfortably earned.

It is usually calculated as EBIT divided by interest expense, and in credit agreements frequently as EBITDA divided by net interest, which produces systematically higher values. The contractual definition should therefore always be checked. A value of 4 means earnings cover interest four times over, while a value close to 1 shows that the operating business barely earns its interest and leaves nothing for amortisation, investment and taxes. In credit agreements the ratio is one of the standard covenants, with a minimum level that depends on sector and risk profile. The distinction from the debt service coverage ratio matters, since that measure also includes amortisation and is therefore stricter: a company can cover interest comfortably and still be unable to meet scheduled repayments. Alongside leverage, interest cover adds information of its own, because it reflects the current interest level: the same debt is easy to carry at low rates and hard at high ones, which matters particularly for floating rate financings and upcoming refinancings.

It should be noted that a high figure alongside low absolute debt says little if heavy investment is due. The ratio measures only interest and not total cash requirements. It should also be checked whether capitalised interest and accrued interest from junior instruments are included, since excluding them presents the real burden far too favourably. Credit analysis therefore always carries the ratio alongside debt service cover.