Interest Coverage Ratio

Interest Coverage Ratio: Definition and Purpose

The interest coverage ratio (also called times interest earned, TIE) measures a company’s ability to pay interest on its outstanding debt from operating earnings. It is a solvency and profitability metric used by lenders, investors, and creditors to assess financial risk and borrowing capacity.

Formula

Interest Coverage Ratio = EBIT ÷ Interest Expense

where EBIT = Earnings Before Interest and Taxes.

Variations commonly use:
* EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) instead of EBIT — yields a higher ratio by excluding depreciation and amortization.
* EBIAT (Earnings Before Interest After Taxes) — deducts taxes for a potentially more conservative view.

How to Calculate (Quick Example)

If quarterly EBIT is $625,000 and monthly interest payments are $30,000:
* Quarterly interest expense = $30,000 × 3 = $90,000
* Interest coverage ratio = $625,000 ÷ $90,000 ≈ 6.94

A ratio of ~6.94 means the company can cover interest payments nearly seven times with its earnings.

Interpreting the Ratio

• Above 3: Generally considered healthy for many industries (comfortable cushion).
• Around 1.5 or lower: Weak — ability to meet interest payments may be questionable.
• Below 1: Concerning — current earnings are insufficient to cover interest; the company may need to use cash reserves or borrow more.
• Industry context matters: regulated utilities may reliably operate with lower ratios; cyclical or volatile sectors typically require higher coverage.

Why It Matters

• Indicates solvency: shows how many times a firm can meet interest obligations from operating earnings.
• Signals borrowing capacity: lenders use it to price debt and set covenants.
• Highlights sensitivity to interest rate changes: rising interest rates can reduce coverage and strain profitability.

Limitations and Caveats

• Cross-industry comparisons can be misleading—compare companies within the same sector and business model.
• Firms may compute or present the ratio using different earnings metrics or exclude certain debts; verify what is included.
• One-period snapshots can hide trends — review multiple quarters/years to see direction and stability.

Practical Tips for Investors and Analysts

• Check both EBIT‑ and EBITDA‑based coverage for a fuller picture.
• Track the ratio over time to detect improving or deteriorating trends.
• Combine with other solvency ratios (debt-to-equity, total-debt-to-assets) and cash-flow analysis.
• Consider interest coverage alongside covenant terms in debt agreements.

Key Takeaways

• The interest coverage ratio = EBIT ÷ Interest Expense and shows how easily a company can pay interest from earnings.
• Higher ratios indicate greater margin of safety; lower ratios signal higher default risk.
• Always interpret the ratio in industry context, examine the calculation method, and look at multi-period trends.