Wall Street Prep

Interest Coverage Ratio

Learn the Steps to Calculating Interest Expense Coverage Ratios

Learn Online Now

Interest Coverage Ratio

Key Learning Objectives
  • 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?

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”.

Interest Expense Formula

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

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 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:

dl
Submitting ...

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.

Model Assumptions

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

Interest Expense Financials

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.

Interest Expense Output

Comments
guest
0 Comments
Inline Feedbacks
View all comments
Learn Financial Modeling Online

Everything you need to master financial and valuation modeling: 3-Statement Modeling, DCF, Comps, M&A and LBO.

Learn More
X

The Wall Street Prep Quicklesson Series

7 Free Financial Modeling Lessons

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.