The interest coverage ratio is one of several debt ratios used by market analysts. The formula allows investors or analysts to determine how comfortably interest on all outstanding debt can be paid by a company. The ratio is calculated by dividing earnings before interest and tax (EBIT) by interest on debt expenses (the cost of borrowed funding) during a given period of time, usually annually.
The equation is as follows:
Interest coverage ratio = EBIT / interest on debt expenses
Low Interest Coverage Ratio Could Signify Financial Issues
A bad interest coverage ratio is any number below 1, as this translates to the company's current earnings being insufficient to service its outstanding debt. The chances of a company being able to continue to meet its interest expenses are doubtful even with an interest coverage ratio below 1.5, especially if the company is vulnerable to seasonal or cyclical dips in income.
Although a company with difficulties servicing its debt may manage to stay financially afloat for a significant period of time, it is vital for analysts and investors to stay abreast of the company’s ability to pay off interest obligations. A low interest coverage ratio is a definite red flag for investors, as it can be an early warning sign of impending bankruptcy.
Good Interest Coverage Ratios Vary
The number that constitutes a good, or at least minimally acceptable, interest coverage ratio varies according to the type of business a company is engaged in, as well as the company's individual history of month-to-month or year-to-year revenues. For a company that has shown the ability to maintain revenues at a fairly consistent level, an interest coverage ratio of 2 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 3.
(For related reading, see "What Is the Difference Between Interest Coverage Ratio and DSCR?")