Interest Coverage Ratio

What Is the Interest Coverage Ratio?

The interest coverage ratio is a debt and profitability ratio used to determine how easily a company can pay interest on its outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense during a given period.

The interest coverage ratio is sometimes called the times interest earned (TIE) ratio. Lenders, investors, and creditors often use this formula to determine a company's riskiness relative to its current debt or for future borrowing.

Understanding the Interest Coverage Ratio

The "coverage" in the interest coverage ratio stands for the length of time — typically the number of quarters or fiscal years — for which interest payments can be made with the company's currently available earnings. In simpler terms, it represents how many times the company can pay its obligations using its earnings.

The formula used is:

Interest Coverage Ratio = EBIT Interest Expense where: EBIT = Earnings before interest and taxes \begin{aligned} &\text{Interest Coverage Ratio}=\frac{\text{EBIT}}{\text{Interest Expense}}\\ &\textbf{where:}\\ &\text{EBIT}=\text{Earnings before interest and taxes} \end{aligned} Interest Coverage Ratio=Interest ExpenseEBITwhere:EBIT=Earnings before interest and taxes

The lower the ratio, the more the company is burdened by debt expenses and the less capital it has to use in other ways. When a company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable.

Companies need to have more than enough earnings to cover interest payments in order to survive future, and perhaps unforeseeable, financial hardships that may arise. A company’s ability to meet its interest obligations is an aspect of its solvency and is thus an important factor in the return for shareholders.

Importance of the Interest Coverage Ratio

Staying above water with interest payments is a critical and ongoing concern for any company. As soon as a company struggles with its obligations, it may have to borrow further or dip into its cash reserve, which is much better used to invest in capital assets or for emergencies.

While looking at a single interest coverage ratio may reveal a good deal about a company’s current financial position, analyzing interest coverage ratios over time will often give a much clearer picture of a company’s position and trajectory.

Looking at a company's interest coverage ratios on a quarterly basis for, say, the past five years, lets investors know whether the ratio is improving, declining, or has remained stable and provides a great assessment of a company’s short-term financial health.

Moreover, the desirability of any particular level of this ratio is in the eye of the beholder to an extent. Some banks or potential bond buyers may be comfortable with a less desirable ratio in exchange for charging the company a higher interest rate on their debt.

Example of the Interest Coverage Ratio 

Suppose that a company’s earnings during a given quarter are $625,000 and that it has debts upon which it is liable for payments of $30,000 every month. To calculate the interest coverage ratio here, one would need to convert the monthly interest payments into quarterly payments by multiplying them by three. The interest coverage ratio for the company is $625,000 / $90,000 ($30,000 x 3) = 6.94. This indicates the company has no current problems with liquidity.

On the other hand, an interest coverage ratio of 1.5 is generally considered a minimum acceptable ratio for a company and the tipping point below which lenders will likely refuse to lend the company more money, as the company’s risk for default may be perceived as too high.

If a company’s ratio is below one, it will likely need to spend some of its cash reserves in order to meet the difference or borrow more, which will be difficult for the reasons stated above. Otherwise, even if earnings are low for a single month, the company risks falling into bankruptcy.

Types of Interest Coverage Ratios

Two somewhat common variations of the interest coverage ratio are important to consider before studying the ratios of companies. These variations come from alterations to EBIT.

One such variation uses earnings before interest, taxes, depreciation, and amortization (EBITDA) instead of EBIT in calculating the interest coverage ratio. Because this variation excludes depreciation and amortization, the numerator in calculations using EBITDA will often be higher than those using EBIT. Since the interest expense will be the same in both cases, calculations using EBITDA will produce a higher interest coverage ratio than calculations using EBIT.

Another variation uses earnings before interest after taxes (EBIAT) instead of EBIT in interest coverage ratio calculations. This has the effect of deducting tax expenses from the numerator in an attempt to render a more accurate picture of a company’s ability to pay its interest expenses. Because taxes are an important financial element to consider, for a clearer picture of a company’s ability to cover its interest expenses, EBIAT can be used to calculate interest coverage ratios instead of EBIT.

Limitations of the Interest Coverage Ratio

Like any metric attempting to gauge the efficiency of a business, the interest coverage ratio comes with a set of limitations that are important for any investor to consider before using it.

For one, it is important to note that interest coverage is highly variable when measuring companies in different industries and even when measuring companies within the same industry. For established companies in certain industries, such as a utility company, an interest coverage ratio of two is often an acceptable standard.

A well-established utility will likely have consistent production and revenue, particularly due to government regulations, so even with a relatively low-interest coverage ratio, it may be able to reliably cover its interest payments. Other industries, such as manufacturing, are much more volatile and may often have a higher minimum acceptable interest coverage ratio of three, for example.

These kinds of companies generally see greater fluctuation in business. For example, during the recession of 2008, car sales dropped substantially, hurting the auto manufacturing industry. A workers’ strike is another example of an unexpected event that may hurt interest coverage ratios. Because these industries are more prone to these fluctuations, they must rely on a greater ability to cover their interest in order to account for periods of low earnings.

Because of such wide variations across industries, a company's ratio should be evaluated to others in the same industry — and, ideally, those who have similar business models and revenue numbers.

Furthermore, while all debt is important to take into account when calculating the interest coverage ratio, companies may choose to isolate or exclude certain types of debt in their interest coverage ratio calculations. As such, when considering a company’s self-published interest coverage ratio, it's important to determine if all debts were included.

What Does the Interest Coverage Ratio Tell You?

The interest coverage ratio measures a company's ability to handle its outstanding debt. It is one of a number of debt ratios that can be used to evaluate a company's financial condition. The term "coverage" refers to the length of time — ordinarily, the number of fiscal years — for which interest payments can be made with the company's currently available earnings. In simpler terms, it represents how many times the company can pay its obligations using its earnings.

How Is the Interest Coverage Ratio Calculated?

The ratio is calculated by dividing EBIT (or some variation thereof) by interest on debt expenses (the cost of borrowed funding) during a given period, usually annually.

What Is a Good Interest Coverage Ratio?

A ratio above one indicates that a company can service the interest on its debts using its earnings or has shown the ability to maintain revenues at a fairly consistent level. An interest coverage ratio of two or better may be minimally acceptable to analysts or investors. For companies with historically more volatile revenues, the interest coverage ratio may not be considered good unless it is well above three.

What Does a Bad Interest Coverage Ratio Indicate?

A bad interest coverage ratio is any number below one as this means that the company's current earnings are insufficient to service its outstanding debt. The chances of a company being able to continue to meet its interest expenses on an ongoing basis are still doubtful even with an interest coverage ratio below 1.5, especially if the company is vulnerable to seasonal or cyclical dips in revenues.