Interest Coverage Ratio Explained: Can the Company Pay Its Debts?
The interest coverage ratio shows how many times a company's operating profit covers its interest bill: interest coverage = EBIT ÷ interest expense. Under the Five Criteria we want at least 5x, because that leaves room for profits to fall by 80% before the company can no longer pay its interest from earnings.
Debt is not dangerous because it exists. It becomes dangerous when the cost of carrying it eats into the profit the business needs to survive a bad year. Interest coverage is the quickest way to see how close to that line a company is standing.
Where this fits: interest coverage is one of the three tests for Criterion 4, "Is the balance sheet sound?", in the Five Criteria framework. The hub for Criterion 4 is long-term debt explained, which covers all three tests together. This article goes deeper on coverage alone.
What Is the Interest Coverage Ratio?
The interest coverage ratio, sometimes called times interest earned, compares the profit a business makes from its operations with the interest it owes lenders. A ratio of 8x means operating profit is eight times the interest bill.
Where net debt/EBITDA measures how big the debt is, interest coverage measures how heavy it feels each year. A company can have modest debt but poor coverage if rates are high, or large debt but good coverage if it borrowed cheaply for a long time.
The interest coverage formula
Interest coverage = EBIT ÷ Interest expense
EBIT is earnings before interest and tax, usually reported as operating income or operating profit on the income statement.
Interest expense is the cost of the company's borrowing for the year. It appears as interest expense or finance costs, and the notes break it down further.
If a company has operating income of $150 million and interest expense of $20 million, its interest coverage is 7.5x.
How much room does each level leave?
The most useful way to read coverage is to ask how far profit could fall before interest is no longer covered. The answer is simply 1 − (1 ÷ coverage).
Interest coverage | EBIT could fall by | Five Criteria view |
10x | 90% | Very comfortable |
5x | 80% | Meets the house minimum |
3x | 67% | Below default; needs a very stable business |
2x | 50% | One bad year from trouble |
1x or less | 0% | Interest not covered by profit |
This is why 5x is the house minimum rather than 2x or 3x. Recessions can cut operating profit sharply, especially in businesses with high fixed costs. A 5x cover survives almost anything short of a collapse. A 2x cover can be wiped out by an ordinary downturn.
Worked Example: Two Companies and a Rate Shock
Here are two hypothetical companies with the same operating profit. They differ only in how much they borrowed and on what terms.
Company A has $300 million of debt at a fixed 4%, not due for repayment for six years.
Company B has $600 million of debt at a floating rate, currently 4%.
Scenario | Company A | Company B |
EBIT | $120m | $120m |
Interest expense | $12m | $24m |
Interest coverage | 10.0x | 5.0x |
Today both pass the house test. Company B sits right on the 5x line.
Step 1: Interest rates rise by three percentage points
Company A's fixed-rate debt costs the same as before. Company B's floating-rate debt resets to 7%.
After the rate rise | Company A | Company B |
EBIT | $120m | $120m |
Interest expense | $12m | $42m |
Interest coverage | 10.0x | 2.9x |
Nothing changed in Company B's business. Its customers, margins and products are all the same. Yet its coverage fell by more than 40% in a year.
Step 2: A recession cuts EBIT by 30%
Now the economy slows and operating profit falls to $84 million for both companies.
Rate rise plus recession | Company A | Company B |
EBIT | $84m | $84m |
Interest expense | $12m | $42m |
Interest coverage | 7.0x | 2.0x |
Company A still covers its interest seven times and can keep investing. Company B now spends half of its operating profit on interest. It may have to cut its dividend, sell assets or issue shares at a depressed price. That last option permanently shrinks existing owners' stake, as our guide to stock dilution explains.
The long-term debt hub runs a similar recession test on leverage. This example shows the other half of the risk: the price of the debt can change even when the amount does not.
Variations of the Interest Coverage Ratio
You will see several versions quoted. They answer slightly different questions.
Version | Formula | When to use it |
EBIT coverage | EBIT ÷ Interest | Our default; conservative and simple |
EBITDA coverage | EBITDA ÷ Interest | Common in loan agreements; flatters asset-heavy firms |
EBITDA minus capex | (EBITDA − Capex) ÷ Interest | Capital-intensive businesses |
Fixed-charge coverage | (EBIT + Lease costs) ÷ (Interest + Lease costs) | Retailers, airlines and others with large leases |
We use EBIT because depreciation reflects real equipment and buildings that wear out and must be replaced. EBITDA coverage treats that money as if it were free to pay lenders, which it is not over the long run.
EBITDA minus capital expenditure is often the most honest version for heavy industries. If a company must spend most of its EBITDA just to maintain its assets, very little is left for interest, whatever the EBITDA coverage says.
Where to Find the Numbers (and What to Adjust)
EBIT and interest expense are on the income statement, but a few details are worth checking in the notes.
Gross versus net interest
Some companies report net finance costs: interest paid minus interest earned on cash. That is fine when cash is stable. But cash can be spent, and interest rates on deposits can fall. For a cautious test, use gross interest expense.
Capitalised interest
Companies building large assets, such as plants or property, may add the interest on construction loans to the cost of the asset instead of expensing it. That interest is still paid in cash. Add it back to interest expense for a truer picture.
Leases
Under IFRS, used by most companies outside the United States, most lease costs are split into depreciation and interest, so lease interest already sits in finance costs. Under US GAAP, operating lease costs usually stay inside operating expenses. When you compare a European retailer with an American one, check which rules apply.
One-off items in EBIT
Large restructuring charges or asset sale gains can distort a single year. Use underlying operating profit, but be sceptical of "one-off" costs that appear every year.
Sector Caveats
Banks and insurers
For banks, interest expense is the cost of their raw material, not a financing choice. Interest coverage does not apply. They are assessed with capital ratios instead, which is a sector exception that does not change the default.
Utilities and infrastructure
Regulated utilities and infrastructure owners often run with lower coverage than our default. Their revenue is usually steadier, and lenders accept thinner cover. A company like this may fail the house test on paper; treat it as a sector exception and look hard at how predictable its earnings really are.
REITs
Real estate investment trusts are usually judged on coverage measures based on EBITDA or funds from operations, because property depreciation is large. Again, this is a sector convention, not a change to our default.
Cyclical businesses
For miners, chemical makers, carmakers and similar companies, coverage in a boom year means little. Calculate it on trough or mid-cycle EBIT. If it falls below 5x in a normal downturn, the balance sheet fails Criterion 4.
Companies with net cash
A company with more cash than debt may show a huge coverage ratio, or even a negative net interest cost. That is good news, but check the gross figure and the maturity dates anyway.
How We Use This in the Five Criteria
The house default for Criterion 4 is a set of three tests. A sound balance sheet has:
Net debt/EBITDA of 2.0x or less.
Interest coverage (EBIT ÷ interest) of 5x or more.
Free cash flow that covers the dividend.
For coverage specifically, I run four quick checks:
Calculate EBIT coverage for the last five years, not just the latest one.
Recalculate it with EBIT cut by 30%, as a simple recession test.
Read the debt note for the share of floating-rate debt and anything due within three years. Estimate the interest bill if that debt reprices at today's rates.
Confirm the trend. Coverage that falls year after year, even from a high level, is a warning.
Having worked in investor relations, I can say that debt maturities and refinancing plans are standard questions from credit analysts. Companies usually disclose a maturity table in the annual report. It takes a few minutes to read and tells you when the next rate reset will hit.
The two leverage tests support each other. A company at 2.0x net debt/EBITDA, paying around 6% on its debt, spends roughly 12% of EBITDA on interest. Unless depreciation is unusually heavy, that usually leaves EBIT coverage above 5x.
Common Mistakes With Interest Coverage
Using EBITDA instead of EBIT. It makes coverage look better by ignoring the real cost of replacing assets.
Checking only the latest year. One good year hides a lot. Use five years and a recession case.
Ignoring floating-rate and maturing debt. Coverage can fall sharply when debt reprices, with no change in the business.
Using net interest when cash is temporary. Interest income on cash can disappear as fast as the cash.
Missing capitalised interest. It is real cash paid to lenders even if it does not show as an expense.
Reading a negative ratio as a number. If EBIT is negative, the company is not covering interest at all. There is nothing to rank.
Applying the test to banks. It does not fit how they make money.
For how debt fits into the bigger picture of avoiding permanent loss, see survival first.
Frequently Asked Questions
What is a good interest coverage ratio? Under the Five Criteria, 5x or more on an EBIT basis is the house minimum. Above 10x is very comfortable; below 3x means a modest fall in profit could put the company under real pressure.
How do you calculate the interest coverage ratio? Divide operating profit (EBIT) by interest expense for the same year. A company with $150 million of EBIT and $20 million of interest has coverage of 7.5x.
What does an interest coverage ratio below 1 mean? It means operating profit is not enough to pay the year's interest. The company must use cash reserves, sell assets, borrow more or raise equity to meet its obligations, all of which can harm shareholders.
Is EBIT or EBITDA better for interest coverage? EBIT is more conservative and is what we use for the house test. EBITDA coverage is common in loan agreements, but it ignores depreciation, which reflects real assets that must eventually be replaced.
Your Next Step
Calculate EBIT coverage for one company you own, then repeat it with EBIT cut by 30% and with floating-rate debt repriced higher. Read long-term debt explained to add the other two Criterion 4 tests, and review the cash flow statement to see whether the interest is really being paid from cash. Then score the full company with the Five Criteria Checklist.
About the author: Cameron Hayes is a senior investor relations and finance professional who has worked in IR at Nasdaq Copenhagen-listed companies including Nilfisk and Maersk Drilling. He holds an MSc from Copenhagen Business School and a BCom from the University of Ottawa, and founded Gingernomics to teach individual investors the Five Criteria framework. More about Gingernomics.
The content on Gingernomics is for educational and informational purposes only and does not constitute financial advice. Always do your own research and consult a licensed financial advisor before making any investment decisions. Past performance is not indicative of future results.
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