What is the Interest Coverage Ratio?
The interest coverage ratio measures the amount of earnings a business has available to make interest payments. It is sometimes called the interest cover ratio, times interest earned ratio, interest coverage or simply interest cover.
Formula for Interest Coverage Ratio
The ratio is calculated by dividing the earnings before interest and tax by the interest expense as shown below.
- Earnings before interest and tax (EBIT) is shown in the income statement. It is sometimes referred to as profit before interest and tax (PBIT).
- The interest expense is also found in the income statement and may be called interest or interest paid (interest received should be excluded from the calculation).
How to Calculate the Interest Cover Ratio
|Cost of sales||176,000|
|Earnings before interest and tax||64,000|
|Profit before tax||44,000|
|Profit after tax||35,000|
In the example above the earnings before interest and tax 64,000 and the interest expense is 20,000. The interest coverage ratio is given by using the formula Interest Coverage multiple = Earnings before interest and tax / Interest expense = 64,000 / 20,000 = 3.20.
Interest Coverage Ratio Interpretation
The interest cover ratio is a measure of the ability of a business to make interest payments on its debt, as such it is a measure of the credit worthiness of the business.
The business should aim to have a high interest coverage ratio which implies a profitable business with low debt. A high interest coverage will give a measure of security to the people who have lent the business money.
Useful tips for Using the Interest Coverage Ratio
- The interest coverage ratio will vary from industry to industry. To make comparisons you need to use a comparable business operating in your sector.
- The interest cover ratio would normally be in the range of 1.5 to 2.0 although is can go higher in the short term for some businesses.
- If the coverage ratio is less than 1 it means that the earnings available is not sufficient to cover the interest expense.
- The interest cover ratio may be referred to as times interest earned or times interest earned ratio.
- The interest coverage ratio is one of the criteria a bank will look at when considering whether to lend to the business.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.