What is an Interest Coverage Ratio?
An Interest Coverage Ratio measures a company’s ability to meet required payments (specifically, interest expense) 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.
- What does an interest coverage ratio measure?
- How is an interest coverage ratio different from a leverage ratio?
- What are the most common examples of interest coverage ratios?
- How does paid-in-kind interest (PIK) impact the assessment of interest coverage ratios?
In This Article
Interest Coverage Ratio Overview
One method of assessing the financial risk associated with a company 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
Another common approach to evaluate a company’s risk of default is the analysis of coverage ratios.
Besides the mandatory debt principal obligations coming due on the date of maturity, companies must also track their interest expense payments.
Interest coverage ratios measure the ability of companies to meet scheduled interest obligations coming due on time.
The more principal that a company has, the more interest expense the company will owe.
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.
- Operating Cash Flow Metrics: EBITDA, EBIT, (EBITDA – CapEx)
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.
Operating income (EBIT) is often the most common variation used in the calculation of interest coverage ratio as the “middle ground,” and is usually what is referred to by practitioners who mention the “interest coverage ratio”.
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 interest 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 in Coverage Ratios
Note that 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.
Interest Coverage Ratio Types
|EBITDA Interest Coverage Ratio||EBITDA ÷ Interest Expense||
|EBIT Interest Coverage Ratio||EBIT ÷ Interest Expense||
|EBITDA Less CapEx Interest Coverage Ratio||(EBITDA – CapEx) ÷ Interest Expense||
|Fixed Charge Coverage Ratio (FCCR)||(EBITDA – CapEx) ÷ (Interest Expense + Current Portion of Long-Term Debt)||
EBITDA Interest 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 EBITDA interest coverage ratio is 5.0x.
- EBITDA Interest 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 Excel Template
Now that we’ve discussed the purpose of interest expense ratios as well as the most frequent variations, we can now practice an example calculation.
For access to the model template, fill out the form below:
Interest Coverage Ratio Model Assumptions
To begin, we’ll first list out the model assumptions to be used throughout our exercise.
As of Year 0, the first year of our projections, our example company has the following financials.
Year 0 Income Statement
- EBITDA: $60m
- EBIT: $40m
- CapEx: $25m
- Total Interest Expense: $30m
Then, 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.
Interest Coverage Ratio Example Calculation
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 Interest Coverage Ratio: 2.0x → 4.4x
- EBIT Interest Coverage Ratio: 1.3x → 2.7x
- (EBITDA – CapEx) Interest 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.