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Interest Coverage Ratio

Guide to Understanding the Interest Coverage Ratio

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Interest Coverage Ratio

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.

In contrast to leverage ratios, coverage ratios compare a cash flow metric that captures the company’s operating cash flow in the numerator to the amount of interest expense on the denominator.

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.

Formula
  • 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

Coverage Ratio Formula Purpose
EBITDA Interest Coverage Ratio
  • EBITDA ÷ Interest Expense
  • Measures the number of times EBITDA can service the interest expense coming due
EBIT Interest Coverage Ratio
  • EBIT ÷ Interest Expense
  • Measures the number of times EBIT can service the interest expense coming due
EBITDA Less CapEx Interest Coverage Ratio
  • (EBITDA – Capex) ÷ Interest Expense
  • Measures the number of times that EBITDA, once Capex is deducted, can service the interest expense coming due
Fixed Charge Coverage Ratio (FCCR)
  • (EBITDA – Capex) ÷ (Interest Expense + Current Portion of Long-Term Debt)
  • Measures a company’s ability to service all required, short-term financial obligations – can often adjust for rent expense as well
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.

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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.

Interest Coverage Ratio Calculator

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