Interest coverage

What it means

Interest cover is a financial ratio calculated as operating profit, usually EBIT, divided by interest expense for the same period. It shows how many times the company’s operating result covers the interest on its debts, and so how much headroom it has before interest becomes unmanageable.

A value of three means operating profit is three times the interest bill. The higher the ratio, the more comfortably the company handles its debt. A value close to one indicates that almost all operating profit goes on interest, and below one that the company does not earn its interest.

Interest cover is one of the basic leverage financial ratios. Unlike DSCR, which compares cash flow with all debt service including principal, it tracks only the ability to pay interest. The two are therefore often used together.

How it works in practice

Banks assess interest cover when approving a loan and often write it into the agreement as a covenant with a minimum level. For clients with loans, we therefore calculate it quarterly so they know in advance whether they are nearing a breach.

When planning new borrowing, we model how interest cover would change at higher rates. With floating-rate loans, rising rates can worsen the ratio significantly even if the business is performing just as well operationally.

If the ratio deteriorates, options include reducing debt, refinancing on better terms, fixing the rate or improving operating profitability. It is important to start talking to the bank before the covenant is formally breached.

What to watch out for

Interest cover based on EBIT ignores the fact that the company must also repay principal. A company with good interest cover can still struggle with repayments if its loans have short maturities. It should be monitored alongside cash flow and DSCR.

When testing against a covenant, calculate it exactly as the contract defines it. Banks sometimes use EBITDA instead of EBIT, include or exclude certain interest, and use trailing twelve-month figures. A different method can give a completely different result.