What is interest coverage ratio?

What is interest coverage ratio?

The interest coverage ratio measures how many times your operating income can cover your interest expense. It shows your ability to pay interest on debt. A higher number means stronger debt safety. It's also called times interest earned.

You use this ratio to judge whether a company can handle its debt. Lenders look at it before giving more money. If the number drops, it signals trouble with the ability to pay interest.

How do you calculate interest coverage ratio?

Divide your operating income by your interest expense. That's it. The result tells you how many times you can pay interest. For example, $100,000 in operating income and $20,000 in interest expense gives you 5. That means you can cover interest five times.

What does a good interest coverage ratio look like?

A ratio above 2.5 is safe. Below 1.5 is risky. Below 1 means you can't pay interest from earnings, which is why lenders treat 2.5 as the comfort line for debt safety.

You'd need to borrow or use cash to cover interest. The first tripwire that tells you whether a borrower can pay sits at 1.5, so watch it trend down. Yet too high is its own warning: a far-above-peer number can mean you are underusing leverage.

What are the variations?

Some companies use EBITDA instead of operating income. That adds back depreciation and amortization. It gives a higher ratio. Others use EBIAT, which subtracts taxes. Each version changes the number.

A related test called the fixed charge coverage ratio, or FCCR, extends the idea. It divides EBITDA minus capital expenditures by interest expense plus the current portion of long-term debt. FCCR equals EBITDA less capex divided by interest plus near-term debt.

FCCR covers more than interest. It also factors in required lease payments and the near-term principal on long-term debt. A company with heavy leases gets a fairer reading from FCCR than from ordinary interest coverage.

The simpler ratio ignores rent and debt repayment. So a retailer can clear basic interest coverage yet still struggle, because leases and principal payments eat cash. FCCR catches what the ordinary number misses.

A ratio above 1 means you can meet fixed charges from operating earnings. Under 1, you cannot cover them without borrowing or selling assets. Lenders lean on FCCR when leases are a large part of a borrower's obligations.

What are the limitations?

The ratio can be gamed. Companies might exclude some debt. Compare only with similar firms in the same industry. A utility can run low and stay safe. A manufacturer needs 3 or higher.

How do lenders use the interest coverage ratio?

Lenders write it into loan agreements as a covenant. A minimum interest coverage ratio is the floor you must hold to stay in good standing. Fall below it and the bank can cut your credit or demand repayment. That makes the number a tripwire, not just a score.

You typically find the threshold in the loan terms, set to match the borrower's risk. Lenders pick a level the company can usually clear but that catches trouble early. When a business scrapes against its minimum, it signals distress before a default ever happens.

The covenant matters because interest payments must keep flowing. A company can report a profit on paper yet still fail to cover its interest in cash. The ratio tells the lender whether cash from operations can meet the fixed charge, or whether the loan is already in danger.

So the same ratio means two things. To you, it is a measure of debt safety. To a bank, it is a binding condition of the loan. Watch the minimum a lender demands, because that is the line past which your credit options start to shut.

The bottom line

The interest coverage ratio is a quick check on debt safety. Use it with other metrics. A low number is a red flag that calls for a closer look at how earnings cover interest expense.