What is an Interest Coverage Ratio?
The Interest Coverage Ratio measures a company’s ability to meet required interest expense payments related to its outstanding debt obligations on time.
There are several variations of interest coverage ratios, but generally speaking, most credit analysts and lenders will perceive higher ratios as positive signs of reduced default risk.
Table of Contents
How to Calculate the Interest Coverage Ratio
Interest coverage ratios measure the ability of companies to meet scheduled interest obligations coming due on time.
Besides the mandatory debt principal obligations coming due on the date of maturity, companies must also service their interest expense payments on schedule to avoid defaulting.
The more debt principal that a company has on its balance sheet, the more interest expense the company will owe to its lenders — all else being equal.
Of the three metrics, EBITDA tends to output the highest value for an interest coverage ratio since D&A is added back, while “EBITDA – Capex” is the most conservative.
Coverage Ratio vs. Leverage Ratios
Another method to measure risk is leverage ratios, which determine how much debt comprises the entire capital structure. Here, the amount of debt carried by a company is compared to either:
- Capital Sources: e.g. Debt-to-Equity Ratio (D/E), Debt-to-Total Capitalization
- Cash Flow Metrics: e.g. Debt-to-EBITDA, Debt-to-EBIT, Debt-to-EBITDA Less Capex
Interest Coverage Formula
The formula to calculate the interest coverage ratio involves dividing a company’s operating cash flow metric – as mentioned earlier – by the interest expense burden.
- Interest Coverage Ratio = EBIT / Interest Expense
The EBIT interest coverage ratio tends to be the most commonly used because it represents the conservative, “middle ground.”
Usually, when practitioners mention the “interest coverage ratio”, it is reasonable to assume they are referring to EBIT.
For purposes related to lending to a potential borrower and/or providing other forms of capital, interest coverage ratios can be helpful in understanding whether the company’s cash flows are sufficient to pay off the required interest payments on its debt.
- Higher leverage ratios equate to more financial risk, meaning the borrower’s probability of defaulting on its required debt payments becomes more of a concern.
- For coverage ratios, however, the lower the number, the riskier the credit health of the borrower – which is the opposite of leverage ratios.
Therefore, the higher the number of “turns” for an interest coverage ratio, the more coverage (and reduced risk), because there is more “cushion” in case the company underperforms.
PIK Interest Treatment
Lending agreements occasionally include interest expense to be paid in the form of “paid-in-kind” interest (or PIK interest), rather than cash interest.
In such cases, the calculated interest expense coverage ratios can be adjusted to exclude the effects of any PIK interest. In effect, only the cash portion of interest expense should be included in the calculation, because PIK is not an actual outflow of cash.
All else being equal, PIK interest increases interest coverage ratios since they are not counted as part of the “interest” line, but note that interest is still accruing to the debt principal and is due at maturity.
Types of Interest Coverage Ratios
|EBITDA Interest Coverage Ratio||
|EBIT Interest Coverage Ratio||
|EBITDA Less CapEx Interest Coverage Ratio||
|Fixed Charge Coverage Ratio (FCCR)||
EBITDA Coverage Ratio Example Calculation
For instance, if the EBITDA of a company is $100 million while the amount of annual interest expense due is $20 million, the coverage ratio is 5.0x.
- EBITDA Coverage Ratio = $100m ÷ $20m = 5.0x
The EBITDA of the company can service the $20m in interest expense five times, which means the company’s operating earnings can pay its current interest payment for five “turns.”
But if the EBITDA coverage ratio were much lower, let’s say only 1.0x, for example, just a slight drop-off in performance for the company could cause a default due to a missed interest expense payment.
Interest Coverage Ratio Calculator – Excel Model Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Step 1: Operating Assumptions
Suppose a company had the following select income statement financial data in Year 0.
- EBITDA: $60 million
- EBIT: $40 million
- Capex: $25 million
- Total Interest Expense: $30 million
From Year 1 and onward, we’ll use a step function that assumes each line item will grow by the following:
- EBITDA: 4.0% Growth Rate in Year 1 and Increase of +2.0% / Year
- EBIT: 3.5% Growth Rate in Year 1 and Increase of +1.5% / Year
- Capex: 5.0% Growth Rate in Year 1 and Increase of +2.0% / Year
- Total Interest Expense: Decline by –$2m / Year
By the end of Year 5, EBITDA is growing at 12.0% year-over-year (YoY), EBIT is growing by 9.5%, and Capex is growing at 13.0%, which shows how the company’s operations are growing.
However, the pace of the required reinvestments (i.e. Capex) to fund the growth is also rapidly increasing in line with the EBITDA growth.
In contrast, the company’s total interest expense is declining from $30m in Year 0 to $20m by the end of Year 5, suggesting the company’s debt principal is declining, which directly leads to lower interest expense since interest is a function of the amount of the outstanding debt principal.
Step 2: Interest Coverage Ratio Calculation Example
Once all the forecasted years have been filled out, we can now calculate the three key variations of the interest coverage ratio.
For each variation, we’ll divide the appropriate cash flow metric by the total interest expense amount due in that particular year.
From Year 0 to Year 5, the coverage ratios shift from:
- EBITDA Coverage Ratio: 2.0x → 4.4x
- EBIT Coverage Ratio: 1.3x → 2.7x
- (EBITDA – Capex) Coverage Ratio: 1.2x → 2.5x
Given the outpacing of EBITDA vs EBIT and the growth of Capex being on par with the growth of EBITDA, the EBITDA variation of the calculated interest coverage ratio is the highest, whereas the (EBITDA – Capex) variation is the lowest of the three types, with the EBIT variation coming in the middle.