Calculate and Interpret the Interest Coverage Ratio

The interest coverage ratio is used to measure of the number of times a company would be able to make the interest payments on its debt using its earnings before interest and taxes (EBIT). The ratio is calculated by dividing the company’s EBIT for a selected period by the interest expenses the company has for the same period. As a general rule, the lower the interest coverage ratio the greater the possibility of bankruptcy for the company due to its high debt burden. On the other hand, a very high interest coverage ratio may suggest that the company is missing out on opportunities to expand its earnings through leverage.

The formula for the interest coverage ratio can be written as:

As a rule of thumb, investors should be wary of stocks with an interest coverage ratio of less than 1.5. A ratio of less than 1 is indicative of a business that is having a difficult time generating the cash required to meet its interest obligations. A review of the company’s earnings can be helpful for investors as a company that has demonstrated consistent earnings results can operate with a lower coverage ratio.

It is worth noting that some industries tend toward higher interest coverage ratios than other industries. Companies that operate in cyclical industries, for example, often see wide swings in their interest coverage ratios. Given that, the best use of the measure is typically in comparing companies within the same industry.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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