What interest coverage tells you
The interest coverage ratio, also called times interest earned, compares two figures from the same income statement. Operating income, often called EBIT (earnings before interest and taxes), is the profit from running the business before interest and income tax are deducted. Interest expense is the interest charged on the business’s borrowings for the same period. Since interest is paid out of operating profit, the ratio shows how much room the business has to meet its interest bill.
A result of 5.00 means operating income was five times interest expense, so operating profit could fall by 80% before it no longer covered the interest. A result below 1.00 means operating income did not cover interest for the period, and a negative result means an operating loss.
Reading a high or low result
What is normal varies by industry and by how stable profits are. A business with steady, predictable earnings can carry a lower ratio more comfortably than one whose profits swing from year to year.
- A higher ratio leaves more room for profits to fall before interest becomes hard to pay. It can also simply mean the business has little debt.
- A lower ratio leaves less room. A dip in profits could mean interest has to be paid from cash reserves or new borrowing rather than from operating profit.
Compare the ratio with the same business over several periods, or with similar businesses, rather than reading one year on its own.
What the ratio does not show
- It ignores principal. Loan repayments are not interest expense, so a business can cover its interest several times and still struggle to meet repayments. The debt service coverage ratio includes principal as well as interest.
- Operating income is not cash. It includes non-cash costs such as depreciation, and sales that customers have not yet paid for.
- It looks backward. The interest expense for the period may not reflect higher rates on variable-rate loans or on debt that is refinanced later.
- EBIT and operating income are often treated as the same figure, as this calculator does, but they can differ when a business has income or costs outside its main operations. Use the same basis each period.
Common mistakes
- Using net income instead of operating income. Net income is after interest and tax, so it understates the profit available to pay interest.
- Using net interest (interest expense minus interest income) in one period and gross interest expense in another.
- Taking a high ratio as proof that the debt is affordable without checking the repayment schedule.
- Comparing operating income for part of a year with a full year of interest expense.
Related measures
The debt-to-equity ratio shows how much the business owes relative to its equity, while interest coverage shows whether earnings can carry the interest on it. Some analysts use EBITDA instead of EBIT, which adds back depreciation and amortization and so gives the same or a higher figure; EBIT vs EBITDA explains the difference. The operating profit margin shows how much operating income each unit of revenue produces.