The interest coverage ratio is a measurement of 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. A good interest coverage ratio is considered important by both market analysts and investors, since a company cannot grow, and may not even be able to survive, unless it can adequately pay the interest on existing obligations to creditors.
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. A company that has very large current earnings beyond the amount required to make interest payments on its debt has a larger financial cushion against a temporary downturn in revenues. A company barely able to meet its interest obligations with current earnings is in a very precarious financial position, as even a slight, temporary dip in revenue may render it financially insolvent.
The interest coverage ratio is arrived at through a simple calculation; divide earnings before interest and taxes (EBIT) by the amount required to pay interest on all of the company's outstanding debts to creditors. For example, if a company's earnings before taxes and interest amount to $50,000, and its interest payment requirements total $25,000, then the company's interest coverage ratio is 2.
What constitutes a good interest coverage varies not only between industries, but also between companies in the same industry. Generally, an interest coverage ratio of at least 2 is considered the minimum acceptable amount for a company that has solid, consistent revenues, such as an energy company. Analysts prefer to see a coverage ratio of 3 or better. In contrast, a coverage ratio below 1 indicates that a company cannot meet its current interest payment obligations and therefore is not in good financial health.