Interest coverage is a financial ratio that measures a company's ability to pay interest expenses on its debt obligations. It shows how many times a company's operating income (or earnings before interest and taxes, EBIT) covers its interest expenses.
The interest coverage ratio is calculated as follows:
Interest Coverage Ratio = EBIT / Interest Expenses
• EBIT is the company's earnings before interest and taxes
• Interest Expenses are the interest payments made by the company on its debt obligations
A higher interest coverage ratio indicates that a company has more earnings to cover its interest payments, which means it is better able to meet its debt obligations. A low interest coverage ratio, on the other hand, suggests that a company may have difficulty meeting its interest payments and may be at risk of defaulting on its debt.
Let's say a company has an EBIT of $10 million and pays $1 million in interest expenses on its debt. The interest coverage ratio for this company would be:
Interest Coverage Ratio = $10 million / $1 million = 10
This means that the company's earnings are 10 times its interest expenses, indicating that it has a strong ability to pay its interest obligations. Lenders and investors may view this favorably, as it suggests that the company has a lower risk of defaulting on its debt.
However, if the same company had an EBIT of $3 million and paid $2 million in interest expenses, the interest coverage ratio would be:
Interest Coverage Ratio = $3 million / $2 million = 1.5
This indicates that the company's earnings are only 1.5 times its interest expenses, which may suggest that it is at a higher risk of defaulting on its debt obligations. Lenders and investors may view this less favorably, which could lead to a higher cost of borrowing for the company.