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Measuring Interest Coverage

Updated on: March 15, 2007 / 4:46 PM EDT / MoneyWatch

An organization's ability to cover interest payments due on a debt or loan, after all other income and expenses have been accounted for, is known as "interest coverage."

The "interest coverage ratio" reveals how comfortably an organization can meet its interest payments. It helps determine whether an organization is creditworthy, and is also seen by banks and other financial institutions as an indication of overall business health.

What to Do

Also known as "times interest earned," interest coverage is calculated as a ratio: earnings after operating and non-operating income and expenses (but not interest and tax) have been accounted for—EBIT—divided by interest expenses.

So, expressed as a formula:

EBIT / interest expenses = Interest coverage ratioExample:

Suppose interest expenses for the year are $1.2 million, and an organization's EBIT is $4.8 million. The interest coverage ratio is therefore:

4.8/1.2 or 4:1

The ratio can been adapted to fit different situations. For example, to analyze the ability to meet interest payments using cash flow alone (EBIT includes accrued sales and other unrealized income), the "cash flow interest coverage ratio" is more appropriate:

Operating cash flow + interest expenses + tax / interest expenses = Cash flow interest coverage ratio

Similarly, a "fixed-charge coverage ratio" indicates an organization's ability to meet its fixed charges—which could be anything from paying a lease to buying dividends on preferred stock, or paying into a fund set aside for debt retirement:

EBIT + fixed expenses / interest + fixed expenses = Fixed charge coverage ratio

What You Need to Know

A higher ratio is likely to reflect a healthier financial position, while a lower ratio might indicate trouble ahead.
A ratio of less than 1 suggests that an organization is having difficulty meeting its borrowing obligations, and that even a small hike in interest rates or a downturn in sales could tip them into unprofitability.
A healthy interest coverage ratio is generally at least 1.5. In some sectors, it needs to be at least 2.0.
The interest coverage ratio is seen as a more effective indicator than total debt, because an organization's financial obligations over a specific period are more significant than the debt itself.
To establish a more accurate long term picture, it makes sense to monitor the interest coverage ratio over several accounting periods.

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