Interest Coverage Ratio

Interest Coverage Ratio (aka ‘Times Interest Earned’) is calculated by dividing a company's EBITDA (not EBIT!) by the company's interest expenses of the same period. This ratio is supposed to show how easily a company can pay interest on its outstanding debt.

The lower the ratio, the more the company is burdened by its debt expense. When a company's interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable. An interest coverage ratio below 1 (100%) indicates the company is not generating sufficient revenues to satisfy interest expenses. A company that barely manages to cover its interest costs may easily fall into bankruptcy if its earnings suffer for even a single month.

Unfortunately, this ratio is quite misleading. It tends to present interest coverage situation better than it actually is. Why? Because EBITDA is calculated on an accrual basis and you need cash to make your interest payments. Cash that might be stuck in your accounts receivable. Or inventory. Or other current assets.

That’s why to make sure that your interest payments are well-covered, you will really need a solid methodology, highly efficient process and very competent personnel for managing your cash and the whole working capital.