## What is the 'Interest Coverage Ratio'

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

The method for calculating interest coverage ratio may be represented with the following formula:

or

Interest coverage ratio is also called “times interest earned.”

Next Up

## BREAKING DOWN 'Interest Coverage Ratio'

Essentially, the interest coverage ratio measures how many times over a company could pay its current interest payment with its available earnings. In other words, it measures the margin of safety a company has for paying interest during a given period, which a company needs in order to survive future (and perhaps unforeseeable) any financial hardship that may arise. A company’s ability to meet its interest obligations is an aspect of a company’s solvency, and is thus a very important factor in the return for shareholders.

To provide an example of how to calculate 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 / (\$30,000 x 3) = \$625,000 / \$90,000 = 6.94.

Staying above water with interest payments is a critical and ongoing concern for any company. As soon as a company struggles with this, 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.

The lower a company’s interest coverage ratio is, the more its debt expenses burden the company. When a company's interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable. 1.5 is generally considered to be a bare 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.

Moreover, an interest coverage ratio below 1 indicates the company is not generating sufficient revenues to satisfy its interest expenses. If a company’s ratio is below 1, 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 reasons stated above. Otherwise, even if earnings are low for a single month, the company risks falling into bankruptcy.

Generally, an interest coverage ratio of 2.5 is often considered to be a warning sign, indicating that the company should be careful not to dip further.

Even though it creates debt and interest, borrowing has the potential to positively affect a company’s profitability through the development of capital assets according to the cost-benefit analysis. But a company must also be smart in its borrowing. Because interest affects a company’s profitability as well, a company should only take a loan if it knows it will have a good handle on its interest payments for years to come. A good interest coverage ratio would serve as a good indicator of this circumstance, and potentially as an indicator of the company’s ability to pay off the debt itself as well. Large corporations, however, may often have both high interest coverage ratios and very large borrowings. With the ability to pay off large interest payments on a regular basis, large companies may continue to borrow without much worry.

Businesses may often survive for a very long time while only paying off their interest payments and not the debt itself. Yet, this is often considered a dangerous practice, particularly if the company is relatively small and thus has low revenue compared to larger companies. Moreover, paying off the debt helps pay off interest down the road, as with reduced debt the interest rate may be adjusted as well.

## Uses of 'Interest Coverage Ratio'

While looking at a single interest coverage ratio may tell a good deal about a company’s current financial position, analyzing interest coverage ratios over time will often give a much clearer picture about a company’s position and trajectory. By analyzing interest coverage ratios on a quarterly basis for the past five years, for example, trends may emerge and give an investor a much better idea of whether a low current interest coverage ratio is improving or worsening, or if a high current interest coverage ratio is stable. The ratio may also be used to compare the ability of different companies to pay off their interest, which can help when making an investment decision.

Generally, stability in interest coverage ratios is one of the most important things to look for when analyzing the interest coverage ratio in this way. A declining interest coverage ratio is often something for investors to be wary of, as it indicates that a company may be unable to pay its debts in the future.

Overall, interest coverage ratio is a very good assessment of a company’s short-term financial health. While making future projections by analyzing a company’s interest coverage ratio history may be a good way of assessing an investment opportunity, it is difficult to accurately predict a company’s long-term financial health with any ratio or metric.

## Variations of 'Interest Coverage Ratio'

There are a couple of somewhat common variations of interest coverage ratio that are important to consider before studying the ratios of companies. These variations come from alterations to EBIT in the numerator of interest coverage ratio calculations.

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 will.

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 one might use EBIAT in calculating interest coverage ratios instead of EBIT.

All of these variations of calculating the interest coverage ratio use interest expenses in the denominator. Generally speaking, these three variants increase in conservatism, with those using EBITDA being the most liberal, those using EBIT being more conservative, and those using EBIAT being the most stringent.

## Limitations of '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, like a utility company, an interest coverage ratio of 2 is often an acceptable standard. Even though this is a low number, a well-established utility will likely have very 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, like 3. 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 wide variations like these, when comparing companies’ interest coverage ratios one should be sure to only compare companies in the same industry, and ideally when the companies have similar business models and revenue numbers as well.

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, one should try to determine if all debts were included, or should otherwise calculate interest coverage ratio independently.

To understand more on the importance of this ratio, read Why Interest Coverage Matters to Investors and Debt Ratios: Interest Coverage Ratio.

RELATED TERMS
1. ### Coverage Ratio

A coverage ratio is a measure of a company's ability to service ...
2. ### Asset Coverage Ratio

A test that determines a company's ability to cover debt obligations ...
3. ### EBITDA-To-Interest Coverage Ratio

A ratio that is used to assess a company's financial durability ...
4. ### Current Ratio

The current ratio is a liquidity ratio that measures a company's ...
5. ### Capitalization Ratios

Capitalization ratios are indicators that measure the proportion ...
6. ### Interest Expense

An interest expense is the cost incurred by an entity for borrowed ...
Related Articles
1. Investing

### Analyzing AT&T's Debt Ratios in 2016 (T)

Learn about AT&T Inc. and its key debt ratios, such as the debt-to-equity ratio, interest coverage ratio and cash flow-to-debt ratio.
2. Investing

### Understanding Leverage Ratios

Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
3. Investing

### Analyzing IBM's Debt Ratios in 2016 (IBM)

Look over the debt ratios for the IBM Corporation, such as its debt-to-equity ratio, its interest coverage ratio and its cash flow to debt ratio.
4. Investing

### Financial Ratios to Spot Companies Headed for Bankruptcy

Obtain information about specific financial ratios investors should monitor to get early warnings about companies potentially headed for bankruptcy.
5. Insights

### Why Interest Coverage Matters To Investors

This ratio represents an important factor of shareholders' returns - find out how to analyze it!
6. Investing

### Analyzing Amgen's Debt Ratios in 2016 (AMGN)

Learn about Amgen Inc. and its key debt ratios, such as the debt-to-equity ratio, interest coverage ratio and cash flow-to-debt ratio.
7. Investing

### The Price To Earnings Ratio Explained

The price to earnings ratio is one of the most important ratios in investing. Find out how it is calculated, how it can be used and what it tells investors about a particular stock.
8. Investing

### Key Financial Ratios to Analyze Tech Companies

Understand the technology industry and the companies that operate in it. Learn about the key financial ratios used to analyze tech companies.
9. Investing

### Ratio Analysis

Ratio analysis is the use of quantitative analysis of financial information in a company&rsquo;s financial statements. The analysis is done by comparing line items in a company&rsquo;s financial ...
RELATED FAQS
1. ### What are financial risk ratios and how are they used to measure risk?

Explore some of the primary financial risk ratios that investors and analysts commonly use to evaluate a company's overall ... Read Answer >>
2. ### If a company has a high debt to capital ratio, what else should I look at before ...

Learn about some of the financial leverage and profitability ratios that investors can analyze to supplement examining the ... Read Answer >>
3. ### How can a company quickly increase its liquidity ratio?

Discover what high and low values in the liquidity ratio mean and what steps companies can take to improve liquidity ratios ... Read Answer >>
4. ### What is the formula for calculating the current ratio?

Find out what makes up the current ratio, how to calculate it, and what the result can tell you about a potential investment. Read Answer >>
Hot Definitions
1. ### Gross Margin

A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
2. ### Inflation

Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
3. ### Discount Rate

Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
4. ### Economies of Scale

Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
5. ### Quick Ratio

The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
6. ### Leverage

Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...